Module 19 Integration of the real and monetary

sectors of the economy

Equilibrium of output/income interest rate R which affected investment and
consumption -> affected national income Y, employment and unemp U.
Interest rate R in monetary sector level of income Y affected money demand demand and supply of money M, controlled by monetary authority determine
interest R.
R and Y appear in both real and monetary sector. Therefore equilibrium R and
equilibrium income/output Y are determined simultaneously by intersection of real
and monetary factors.
BUT
Micro economics- market forces determines prices and quantities in both goods and
factor markets.
(equilibrium = demand = supply = no tendency for price change)
Is it possible to have equilibrium in real and monetary sectors, equilibrium in all
factors markets, full emp , stable prices, no inf or def? Possible, in exceptions.
In module 19 integrate real and monetary sectors. In 20 inflation and
unemployment.
Keynes General Theory interest purely monetary phenomenon, based on
demand and supply fixed by central monetary authority. monetary factors may
influence real factors such as income and employment.
Liquidity trap prevents rate falling below certain level so monetary policy along is
ineffective to counteract recession. ( inc in money supply doesnt recue interest so
no effect on aggregate demand).
Quantity theory liquidity trap increase in money leak into speculative balances.
Velocity of circulation V falls, offsetting any increase in money supply M.
So far monetary factors affect real variables.
BUT reverse is also true consumptions function and marginal efficiency of
investments curve also influences interest rate.
Eg private sector closed economy.
Equilibrium when planned savings = investments.
Planned savings depend on consumption functions.
Marginal efficiency of investments curve -> volume of investment inversely related
to interest rate.
Fluctuations in incomes and interests will cause fluctuations in planned
savings and investments
Equilibrium when income and interest are in a relation that produces
equilibrium in savings and investments.
Consumption functions and marginal efficiency of investment are the two parts of
the real sector.
But interest ( and hence level of income) is affected by monetary factors
demand/supply of money.
And demand for money depends on level on money income and interest
( transactions demand for money is high when incomes high. And speculative
demand is high when interest is low). Supply is controlled by monetary authority if
supply reduced, cost of holding money ( interests R) will rise.

The 2 sections real ( consumption function + marginal efficiency f investments) and

monetary (supply+ demand of money) interact to include income level and rate of
interest.
The equilibrium national income and the equilibrium interest rate depend on
simultaneous equilibrium in the real and monetary sectors. This means that
simultaneous equilibrium requires that planned savings equal planned investment
and the demand for money equals the supply of money. If these plans are not
consistent, equilibrium cannot exist.

19.2 Equilibrium interest rates and national income

levels the monetary sectors.
At given income, demand/supply of money determines the interest. But what
determine income level? Relation of income and demand.
If income varies, demand for transactions and precautionary purposes is directly
related. MT+P.

And relation between interest rates and demand of money for speculative purposes
is inverse.
If interest rate is high the opportunity cost of idle speculative money is high, so
demand for spec money is low. If R is low, people want to keep their money liquid
for future better opportunities, so high demand for spec money held in idle
balance. At very high R there is no spec money. At slightly lower R some individuals
start keeping spec money. For low R all spec money is help in idle cash balances.

Altogether ;
If we know level of national income/output Y we can calculate demands for
transaction and precautionary (MT+P). Chart D same as figure 19.1.
Plus if supply of money M is determined by monetary authority = we calculate MS
by M (MT+P). Chart C.
From figure 19.2 we know the relation between R and demand for Ms up until the
horizontal trap Chart B.
Thus for any given Y there is only one R for which total money demand MT+P + MS
equals supply M.
Point A represents interstate rate R1 that produces equilibrium in m monetary
sector when level of income is Y1. ( B would be for R2 and Y2).
Chart B represents the Liquidity money curve LM curve)

Interest higher than R3 the LM curve is vertical money help for transactions only,
none for speculative..
Interests Lower than R1 all money not used in transactions or precautionary is held
in idle balances
Increase in money supply

Increase in money supply represented by shift in 45 line in chart C. from M1 to M2.

New equilibrium points shift LM to LM2.
LM2 traces out equilibrium points for Y and R for money supply at M2.
New equilibrium level for R AT level Y2 is R4. point C .
R4 is less than R2.
Interest rates for lower levels of income dont change Keynesian liquidity trap
the limit below which authority cannot lower interest rate.

Extrapolation of chart B
In LM1, R1 and Y1 represent equilibrium.
Increase in money supply shift to LM2.
If Y1 held fixed than R falls to R2.
Alternatively, if R1 held fixed, level of income must rise to Y2 to ensure equilibrium
in money market.
Given a LM curve, Y is determined once R is known or R is determined once Y is
known.
To determine both at same time the investment savings IS curve is needed..
The IS/LM intersection will determine equilibrium rate of interest and income that
are consistent with equilibrium in the money market and equilibrium in the circular
flow of national income.

19.3 Equilibrium interest rates and national income

levels the real goods sector.
Previously low interest high aggregate demand through private investments
multiplier process expansion (?) of national income. This is the basis.
Back to private sector closed economy. Equilibrium when I = S . I is inversely related
to interest as shown by marginal efficiency of investment. S is a direct function of
income as shown by consumption function.
Income can be consumed or saved. Y C + S.

C is also a function of Y . C = bY where b is the marginal propensity to consume

MPC. Ie the portion spent per additional u nit of income. The portion not spent must
therefore be saved MPS.
And MPC and MPS must equal 1.
Figure 19.6 shows how to derive the various equilibrium points that exist between
national
income and the rate of interest in the real sector.
Curve A level of income and savings ( by removing the portion consumed). S = (1b)Y
Curve B S=I since equilibrium
Curve C Investment per level of interest as shown by marginal efficiency of
investment.
Curve D Income against rate of interest. Line IS shows combination of R and Y that
would make planned investment = planned savings.

At low Y planed S is low and high R is needed to keep balance of S = I

At high Y planned S is high and low R is needed to keep I high and balance S.
From a diff angle. Lower the R the higher the Y equilibrium.

Underlining the IS curve are real factors; marginal efficiency of investment and
consumption function.
If MEI was interest-inelastic changes in interest would minimally change
investment. If also MPC was low then IS would be steep IS1 alternative.
If MEI was interest elastic change in interest relative large change in investments
( multiplier) and if also MPC was high would result in relatively flat IS curve.
IS 1 change in R results in minor change in Y.

LM curve shows R given Y but cannot determine Y

IS curve shows Y given R but cannot determine R.
R and Y can both be determined by intersection of IS and LM curves.

The LM curve
slopes upward to the right, showing that at high levels of income higher rates of
interest are
necessary to ensure that the demand for and supply of money are in equilibrium.
The IS

curve slopes downward to the right, indicating that at higher levels of income low
rates of
interest are necessary to ensure that planned savings and planned investment are
in equilibrium.
At the point of intersection, we shall have a level of national income Y and a rate of
interest R where the demand for money (liquidity) and the supply of money are in
equilibrium
(equilibrium in the monetary sector), and planned savings and planned investment
are in
equilibrium (equilibrium in the real goods sector). Equilibrium in both these sectors
means
that no forces exist to change the rate of interest (Re) or the level of income (Ye).

19.4 The expanded Model : Shifting the Curves.

IS curve was expanded to include government expenditures. Only difference is in B
and D.
Before S = I. Now gov included so S = I + G.
Y generates S. Since gov exp included the actual investment is S G. Therefore
investment available at Y2 is I1. From MEI that I1 associated with R3.
This Y2, R3 creates new curve IS2.
IS2 is the new equilibrium points relating Y and R with added gov expenditure.
Taxes would bring S = G + I back down.
( a trade surplus X > Z would also increase distance G while increase in imports
reduces it).

POLICY SHIFTING;
1) Liquidity Gap + Underemployment
The IS/LM approach integrates monetary factors (the demand for and supply of
money) and real factors (consumption, investment, government expenditure and
net exports) within one analysis.
Starting point is ; IS1 and LM1 with equilibrium corresponding to Re and Ye. ( This is
also less than full emp equilibrium income Yf).
There is a deflationary gap eq level of income is than full emp level of income with
unemployment and less than full capacity output.
In this case monetary policy would be insufficient to reach full emp because interest
rate consistent with full emp income (Yf) is R1. This is below minimum rate of

interest Rm ( set by horizontal line explained by Keynes as liquidity trap

preventing monetary policy to push interest low enough for full emp income).
HOWEVER Given LM1 Yf can be reach by shifting to IS2. This assumes fixed supply
or money and fixed LM curve and would raise in R to R2. This shift could be
achieved with rightward shift in MEI curve ( ie inc investment at any interest rate)
by means of upward shift in consumption function ( ie inc consumption at any inc
level) by creating budget deficit ( inc gov exp, dec taxes or create trade surplus).
If however there was rightward shift in LM to LM2 due to increases money supply
then Yf could be reached with a less marked rightward shift in IS ( ie something like
IS3..) because the inc money will decrease R associated with increased level of
income and hence encourage high investments.
2) Dealing with inf gap.

At LM1 IS1 and responding R1 and Ye, Y is beyond full emp.

These equilibriums will cause an inflationary gap. Level of agg demand higher than
needed to sustain full emp and raising prices.
Aggregate demand is reduced by left shift of LM and/or downward shift of IS.
Eg to do this via monetary policy reduction of money supply shifts LM to LM2 and
at same IS1 the equilibrium level of income falls to Yf. This due to increase in R ->
dec in I and aggregate demand.
If fiscal policy decrease G or inc T creating budget surplus and shift IS to left. If MEI
shifts left this also causes IS to move left. Move to IS2 with corresponding Tf and R3.
Consequential effects on other factors;
shift in MEI ( inv at any int rate) and/or shift in cons function ( exp at any
income) will shift IS to right. Giving higher R and Y at given LM.
Same as functional finance ; budget deficit will cause a rightward shift of IS, and
surplus to left.

Fiscal policy impact on national income/output.

Effectiveness of fiscal and monetary policies depend on shape of IS and LM curves
and stating position of R and Y when policy made.
Below impact of fiscal policy in 3 scenarios. In each shift from IS1 to IS2 because of
eg inc in Gov exp.

A: normal LM curve

B : Liquidity trap Keynesian increase Y by full multiplier effect but R constant.

C; Increase in R but Y unchanged . As previously stated G increased but offset by
decrease in I + C there has been crowding out due to increase in R.
A normal case;

Shift in IS raised both Y and R.

If R had remained the same ( like previous chart B) output would have increased to
Y3. But only increased to Y2 due to partial crowding out.

Effect of monetary policy eg increase money supply. In same 3 scanners. Shift

Lm1 to LM2 . effect depends on slop of IS.

B : horizontal IS - odd due to complete interest elasticity for investment

expenditure. I only at R1. So increase in Y only due to consumption. ( extreme
monetarist)
C: vertical complete interest inelasticity for I in respect to R. Money supply causes
R to decrease but there is no investment or expenditure. (extreme Keynesian)/
A: normal situation - decrease in R stimulates I and C expenditure and through
multiplier Y increase to Y2.