Keynesian is-lm the Keynesian System (II)

Keynesian IS-LM

• The Keynesian System (II):

• Money, Interest, and Income

Problems with the Income-Expenditure Model

• What about prices?

• Don’t they change when AS and AD conditions change?
• Don’t they have an influence?

• Are firms really indifferent to changes in the real wage rate?

• These issues remain to be addressed...

Money in the Keynesian Model

• Recall the classical model:

• Transactions motive: people hold money only to make transactions
• Rejects the store of value theory of the mercantilists, arguing that:
• Money bears no interest, and
• A rational person would not forego a positive return by holding money unless he/she planned to make a transaction.
• People do not hoard money.

Liquidity Preference Theory

• Money is:

• A Medium of Exchange
• A Store of Value
• A Unit of Account

• The first two create demands for money.

Liquidity Preference Theory

• Transactions Motive—yields transactions demand for money

• Store of Value—yields:

• Precautionary Motive—yielding precautionary demand for money
• Speculative Motive—yielding the speculative demand for money

• There are reasons why someone might rationally hoard money!

Speculative Demand (1)

• Keynes considers a portfolio of financial assets.

• All financial assets can be considered as money or bonds:

• Money (M): yields no return
• Bonds (B): yield a return

• Wh = M + B

Speculative Demand (2)

• Example—Perpetuity (a bond that never matures):

• Bond is issued at $1000
• Coupon rate is $50  50/1000=5%
• Later, market interest double to 10%
• How much can you sell the bond for?
• Ans: $500 because 50/500=10%

• When interest rates rise, bond prices fall  capital losses!

Speculative Demand (3)

Precautionary Demand

• People hold money (“precautionary balances”) for unforeseeable expenses.

• These holdings (“balances”) tend to:

• Rise with income, and
• Fall with interest rates.

• Lp = Lp(Y,r) (+) (-)

Ambiguity in the Money Market

• In the classical model:

• Ms = M0 (exogenous)
• Md = Md(Y)
• We used these relationships to create the AD curve.

• In Keynes’ model:

• Ms = M0 (exogenous)
• Md = L(Y,r)
• Ms = Md
• M0 = L(Y,r) is the money market outcome.

Sidenote: Hicks’ Little Apparatus

• Sir John Hicks, 1939, “Mr Keynes and the Classics, a Suggested Interpretation”

• Introduces the IS-LM Model as a way of making sense of Keynes’ General Theory.

Keynesian “Money Market”

• M0 = L(Y,r) is the equilibrium in the money market.

• There is not one single variable that can change to clear the market. There are two!

• The “money market” cannot tell us alone what the supply and demand for money will be.

• Money is not dichotomous.

Hicks’ Interpretation: LM Curve

LM Curve Slopes Upward Because...

• Assumes Ms = M0 (exogenous)

• If Y increases, transactions and precautionary demand increase.

• There will be excess demand in the money markets
• Interest rates will be driven upward

• So Y r, and the LM Curve slopes upward.

LM Curve Slopes Upward Because...

LM and the Money Market

Changes in Money Supply

Capital Market

• Investment I = I(r,E) = I(r)

• But Saving S = S(Y) or S(Yd)

• So there is not a single “price variable” to clear the capital market!

• I(r) = S(Y)  IS Curve: IS = IS(Y,r)

• IS: all those combinations of Y and r which make the “capital market” clear.

• Equivalently, IS is all those combinations of Y and r for which supply = demand in the loanable funds market.

• Thus the real sector cannot be resolved without considering money market outcomes.

• Money is NOT dichotomous.

IS Curve

IS Curve Slopes Downward Because...

Money and Investment

IS-LM

Money-Income Transmission

Notes on IS-LM

• LM is a stock equilibrium (beginning of period. IS is a flow equilibrium (end of period).

• The equilibrium is an equilibrium of flows constrained by stocks. It is a cash-flow equilibrium.

• The time frame is long enough for full adjustment of real income and interest, short enough so stocks do not change.

• IS-LM equilibrium is not permanent. S>0 implies that wealth (allocations) are increasing over time. Therefore LM is shifting due to the stock of bonds. If net investment is positive, then the capital stock grows.

Linearized IS-LM

Linearized IS-LM

Classical Model? (=0)