Monetary Macroeconomics:

Rate of interest, monetary and price theory.

Money does not really have an impact on the economic activity, it may temporarily disturb it, for
example, in the short run, an increase of money will lead to increase of demand for goods and
following it an increase in prices (vice versa), but in the long run it can wont keep it permanently out
of order.

No theory can explain the connection between the 2 effects, long and shot run money effect. More
specifically, the gap between the monetary theory and value theory.

Many scholars began to study the causes for economic fluctuations. With the birth of the
industrialized economy, the phases of the economical cycle were linked to commercial and business
activity. Thus the first indicator of economic activity was produced. The GDP Is the most used
instrument to indicate the fluctuations in the long run.

Most influential economists are Wicksell, Fisher and Keynes.

1.Knut Wicksell: He is famous for his theory of the business cycle based on saving-investment
approach. Recessions and recoveries occur when interest rates fail to coordinate saving and investing.
Key elements of this theory is the distinguished between the natural rate (r) of interest and the bank
(market loan) (i) rate of interest (rent at which banks rent money).

A) when the 2 interest rates are equal (r=i) the prices are stable and the investments = savings.
B)If r>i then i>s then the level of economic activity and prices will go up. This is also known as the
“cumulative process” where the economy expands.
C) if r< i then i<s then economic activity and prices go down.

In B), when the natural rate of interest is bigger than the market loan rate of interest, the investment
activity will increase because returns of the investment is higher than the borrowing cost. Then the
growth phase begins and the fallowing phases occur: the level of output grows beyond full capacity;
the prices rise because of increased demand and bank reserve decrease because they keep lending
money to investors. However, the last phase, where banks empty their reserves, is unsustainable in the
long run, so to stop it banks will increase the interest rate. If r > I, the banks will increase interest rates
so that r=I and a new equilibrium is reached and it is characterized with a higher price level and full
employment level remains in its full capacity.
In C), it is opposite of what happens in B. Investment is smaller than savings since expected return
from investment is below the borrowing cost. Here,instead of economic expansion, a depression and
deflationary phase occurs and it will stop when r = i. When r = I a new equilibrium is reached where
the price level is lower.

2.Irving Fisher: He contributed to theory of interest but he also introduced the theory of economic
crisis called debt-deflation, in which he explains that depression occurs because of debt and price
disturbances. He believed depression in the business cycle occurs because of over-indebtedness and
deflation. According to him, the economy starts from an equilibrium but an external shock could

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produce a recession and bursting of the credit bubble (prices of assets are based on inconsistent views
about the future, they are too high). Once the credit bubble bursts it unleashes severely negative
impacts on the economy:
1.Debt liquidation and distress selling. Firms are brought to an end and it distributes its assets to pay
off debt.
2.Contraction (decline) of money supply as bank loans are paid off
3.Fall of asset prices
4.Greater fall in the net worth of businesses causing bankruptcies
5.Fall in profits
6.Reuction of output, trade and employment
7.Pessimism and loss of confidence
8.Hoarding money
9.A fall in nominal interest rate (int. rate before inflation) and a rise in a deflation adjusted interested
rate (this is worse because investments fall).

Real interest rate ( r) is the nominal interest rate (i) – expected inflation rate. If the expected infl. rate
is low, then the real interest rate will increase even if the nominal interest rate falls. If the real interest
rate increases then investment decreases and the recession will be even more severe.
Stability condition: If the initial over-indebtedness exceeds a threshold level (intensity level that is
barely noticeable) then the process becomes unstable. However, Fisher doesn’t clarify the number of
the threshold level.

3.John Maynard Keynes: Founder of macroeconomics. Most of his ideas are found in the work “
The general theory”.
In this work he considers an economy composed of 4 markets: commodity market, capital market
(part of the commodity market), labor market (determined by aggregate demand), money market.
Money occupies a fundamental role in this theory. However, differently from Walras, only one market
(labor) can be in disequilibrium while the other 3 are in equilibrium.

He calls his theory a general theory because it considers the economy as a whole and it removes Say’s
law because for him, aggregate demand can be smaller than aggregate supply.

In his theory he does not consider the idea of maximizing utility as many economists before him did.
He instead believe in a psychological inclination that makes consumers spend only a fixed fraction (c)
of their earning. (Marginal Propensity to Consume)

Main characteristics of Keynesian law:

-Macroeconomic emphasis: he focused on the determinants of consumption, income, saving, output
and employment. (c, I, s, y, e)

-Demand orientation: He stressed the importance of effective demand (aggregate expenditures, AE –

total amount people and firms plan to spend on goods) as the determinant of the national income,
output and employment. AE consists of the sum of consumption (C), investment (I); government and
net export spending. If the AE is lesser than the full-employment level of output (production level-
when all resources are used efficiently) then the involuntary unemployment (wants to work but is
unemployed) will exist in the economy.

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-Instability in the economy: The instability in the economy is caused by erratic (unpredictable)
investment planning. Variations in the investment plans lead to changes in output and income.
Equilibrium levels of investment and savings are reached when changes in the national income occur,
not in rate of interest.

-Wages and prices rigidity (inability to be changed): Wages cannot be downwardly changed because
of institutional factors such as union contracts, minimum wage laws and implicit contracts. Prices are
also sticky, reduction in demand will only cause reduction in supply and employment rather than
prices.

-Active fiscal and monetary policies: He believed the government should implement these policies to
promote full employment, price stability and economic growth.

THE GENERAL THEORY:

POLICIES TO PROMOTE FULL EMPLOYMENT OUTPUT: GOVERNMENT INTERVENTION:

Keynes challenged classical thinking, in particular in the idea that economies self-correct over time
and that government intervention would do more harm. He contradicted this and stated that the
government should not wait for the economy but should actively stimulate it.
If demand falls and people spending decreases, then the government should increase its spending
which leads to more spending. Initial govern. spending causes a ripple effect and leads to more total
spending. When the government spends money on society it increases income and thus increasing
peoples spending. The people whose wages are now increased, save half the money and the rest of it
they spend on goods and services which becomes someone else’s income. It is a full circle and
Keynes calls it the Multiplier effect.

How might a depression occur?

The idea of the multiplier effect also explains why we have recessions. If people think they’re going
to lose their job, they are more likely to decrease their spending and save money. Because of this,
businesses see their sales drop so they lay off some workers and those workers would decrease their
own spending causing other workers to lose their jobs. This ripple effect pulls the economy down.
Keynesian economists believe that government spending is needed in a recession because, using the
multiplier effect, it would lead to more spending, more jobs and more growth.

Cons of The General Theory and Multiplier effect:

But, this theory is also up to debate. Is it worth for the government to go into debt just to stimulate the
economy ? Even if they choose to increase government spending, how much should they spend? The
multiplier effect is difficult to calculate and it is not known how much people would spend.
Furthermore, if the government uses tax revenue to pay for public projects and services there would
be more spending in some areas and less in others. What if the government borrows the money? : In
this situations, there would be less money for businesses to borrow and there would be higher interest
rates and less investment.

However, Keynesian theory will greatly reduce the great recession.

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CONSUMPTION FUNCTION AND SAVING:

The total spending (consumption) depends on how much people spend of their income. The
proportion of disposable income which individuals spend on consumption is known as propensity to
consume. MPC is the proportion of additional income that an individual consumes.  If income
increases so does spending.
However, saving also has a positive function of income and it also rises as income rises. The marginal
propensity to save (MPS) is the fraction of an increase in income that is not spent and instead used for
saving. The MPS (marginal propensity to save) is similar to MPC (marginal propensity to consume)

INVESTMENT (major component of his theory of effective demand) & INTEREST RATE:

Based in classical theory the interest rate is determined by investment demand and saving. In a graph,
the investment demand is negatively sloped because higher rate of interest means higher cost of
production, higher cost of capital etc. If the interest rate is high then the demand for investment will
be low.
Saving on the other hand is positively sloped because higher interest rate would motivate people to
save more. They prefer more consumption when the interest rate is lower because they wont see any
major gain by saving.
The equilibrium of rate of interest is when saving and investment are equal.

Keynes however is against this theory because in the economy it is not possible to know peoples
savings unless you know the level of income. Because different levels of income would have different
saving schedules. So, to know income beforehand so u can determine the savings, you must know the
investment. It is the investment that through the multiplier effect influences the level of income.
(multiplier effect = income increases with multiplying the investment). However, investment depends
on rate of interest and marginal efficiency of capital (MEC). Thus, rate of interest should already have
been known before the savings.
So in conclusion, rate of interest, rather than being determined by savings and investment, it already
should have been known to determine investment which would determine income and lastly
determine savings.

INTEREST RATE and CONSUMPTION:

People demand money for 3 reasons:

1. Transaction : In order to finance day to day transactions, people should keep some money in
liquid form (savings)
2. Precautionary: They borrow money for any unforeseen emergencies.
3. Speculative: They invest in stock in the market so they can earn money through fluctuations
in the capital market. Buy bonds.

For the first 2 reasons are influenced by income and if income increases the demand for them also
increases.

For the 3rd reason depends on the interest rate and its where people decide if they should buy an
interest building bond or hold it in liquid form. If the interest rate rises then people would invest more

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and save less and vice versa. The bond is given by the agency to the buyer indicating that he will
receive income for some period of time. (fixed income). The income is basically the rate of interest
which the bond carries. The interest rate will stay unchanged depending on the situation of the
economy (stable, falling, increasing). If the rate of interest falls then a new bond will be issued.

The crucial element in the analysis of the interest rate determination is the relationship between
preference for money /savings or bonds. The advantage in saving is the flexibility in transactions but
the disadvantage is that no interest rate is earned.
A persons interest in bonds depends on the comparison of the current and expected interest rate. Thus
there is an opposite relationship between the rate of interest and the demand for money. If current
interest rates are high more people expect them to be lower in the future (the long run) so they prefer
to buy bonds now. This results in a reduction in money demand. At lower interest rates, people would
hold more money. However, the quantity of money supplied depends on the central bank and it is
independent of the interest rate.

In conclusion: The level of investment depends on the MEC (marginal efficiency of capital) and the
market rate of interest. On the other hand, the market rate of interest is determined by the demand of
money (liquidity preferences) and the supply of money.
The interest rate is determined by the speculative reasoning.

EQUILIBRIUM, INCOME, EMPLOYMENT:

If we ignore the government and international trade:

The immediate determinants of income and employment are : Consumption and Investment. These 2
constitute the AGGREGATE EXPENDITURES in the economy.

1.An equilibrium national income: combined levels of consumption and investment = current level of
income or when saving is = to investment.
2.The equilibrium of the money supply and the demanded amount of money also determines the
equilibrium of the interest rate. If the monetary authority decides to shift the money supply then it will
make a shift in the rate of interest as well and a new equilibrium will be determined.

HICKS IS-LM model:

He tried to show that both key features of Keynes’s theory and neoclassical theory can be captured by
the same model.

It is constituted of 4 equations:
1. I=I(i, Y) – investment depends (negatively) on the interest rate and (positively) on the output.
2. S=S(i, Y)- savings depends (positively) on interest rate and (positively) on output.
3. Md= k* Y+ L(i)- demand for money is determined by the demand for transaction purposes
and liquidity purposes. L depends negatively on the interest rate.

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 4. Ms= M- the supply of money is given at the level decided by the central bank.

The IS is determined by the combination of interest rate and output, where aggregate investment and
aggregate saving are equal.

The LM function is given by the combination of interest rates and output, where the demand for
money and aggregate supply of money are equal

The macroeconomics equilibrium is determined as the combination of interest rate and income where
the IS and LM curves intersect. Depending where they intersect it can be a full-employment
equilibrium or underemployment equilibrium. The unemployment equilibrium could develop from a
liquid trap, an investment trap or from rigid wages and prices. Both traps are best avoided by
additional demand through public spending and they would not persist for a long time. Hence, wage
and price rigidities are the only ones to last.

An investment trap is where investment does not respond to any changes in the rate of interest.
A liquid trap is associated with the minimum point of interest rate and it will not fall below that. This
is where everyone prefers holding money rather than investing.