The Keynesian System (II):

Money, Interest, and Income

• Here we explain the role of the interest rate
and money in the Keynesian system.
• Money affects income via interest rate.
• MS increases, interest rate decreases and
increase aggregate demand.
 Interest Rate and Aggregate Demand
• An investment project will be pursued only if its
expected profitability exceeds the cost of
borrowing.
• Here we consider the possible influence of the
interest rate on aggregate demand other than
business investment.
• (1) Residential construction investment
• This is the component of investment in national
income account.
 Interest Rate and Aggregate Demand
• The value of newly constructed houses enters the
GDP account as the houses are built.
• One element of building cost is the cost of borrowing
to finance construction of a house.
• High interest rate mean higher cost to the builder,
these higher cost discourage housing start.
• Home purchases are financed by long term
borrowing in the mortgage market, and high interest
rate include high rates of mortgage interest.
Consumer expenditures on durable goods

• The purchase of a car or an appliances such as

a personal computer or television set a form
of investment. Such purchases are often
financed by borrowing especially car finance.
• Higher interest rate raise the cost of such
purchase and lower aggregate demand.
 Government spending affected by interest
rate
• The state and local government investment
spending is financed by borrowing through
bond issue.
• High interest rate discourage government
spending.
The effects on aggregate demand and equilibrium income as a
result of a change in interest rate.
• A decline in interest rate shift the aggregate
demand curve (C+I1+ GO).
• This shift represents the combined effects of
the interest rate.
• The change in equilibrium income is depend
on the size of aggregate demand caused by
the change in interest rate.
• The more sensitive the component of
aggregate demand are to interest rate
changes, the large will be the shift in the
aggregate demand function and the greater
the effect on equilibrium income.
• The interest sensitivity of aggregate demand
will therefore be important in determining
now effective monetary policy will be in
affecting equilibrium income.
 The Keynesian Theory of Interest Rate
• Keynes believe that the quantity of money played a
key role in determining the rate of interest.
Assumption (money and all non monetary assets
such as bond).
• Money= currency + bank accounts on which a
person can write checks (no interest).
• Bonds + other long term financial assets and stock.
Bonds( interest earning assets and promise to pay
fixed amount at fixed intervals in the future).
• Individual allocates their financial wealth
Wh= B+M
The equilibrium interest rate on bond= demand for bond
equals to supply of bound
If demand for money is greater than supply
Increase the proportion of wealth in the form of money.
If supply of bond is greater than demand Decrease
the proportion of wealth in the form of bond.
• There are two ways to describe the equilibrium
interest rate.
• (1) Supply of bonds =demand for bonds.
• (2) Supply of money= demand for money.
Keynes Emphasized the relationship between money and
interest rate
• Money supply fixed
• Equilibrium interest rate r0 at which MS and
MD equal.
• The equilibrium interest rate is determined by
factors affecting the money supply and money
demand.
• Money supply determined by central bank and
Keynes emphasized the factor the determine
money demand.
 The Keynesian Theory of Money Demand

• (1)Transaction Demand
• Medium of exchange
• Individual hold money for transactions.
• Increase amount of money, increase volume of
transaction.
• Transaction demand for money is assumed to
depend positively on the level of income.
• Transaction demand for money would be expected
to be negatively related to the rate of interest.
• (2) Precautionary Demand
• Expenditure on medical or repair bills
• Precautionary demand depends positively on
income.
• Interest rate economize the precautionary motive.
• (3) Speculative Demand
• If market price of bond $1000
• Coupon payment $50
• Interest rate 5%
• (50/1000= 0.05 or 5%)
• Suppose current market rate of interest is 5%
the same prevailed when you bought.
• In this case bound will sell for $ 1000, it would
yield the current interest rate 5%.
• Coupon payment
• A coupon payment on a bond is the annual
interest payment that the bond holder
receives from the bond’s issue date until it
matures. Coupon rate= coupon paid per
year/bond face value
• Now interest rate increase 10%
• The coupon payment is $50 per year
• 50/0.10 = $ 500
• (50/500= 0.10 or 10%)
• So previously you paid $1000 and now you sell
$500. A rise in the market interest rate results
in a capital loss on previously existing bond.
• (here lower the speculative demand for
money).
• Now if interest rate decrease to 2%
• The bond price 50/0.02 = 2500
• 50/2500 = 0.02 or 2%
• A decline in interest rate results in a capital
gain on previously existing bonds.
• Return on money = 0
• Expected return on bond= interest earnings +
expected capital gain
• Expected return on bond= interest earning −
expected capital loss.
• If r decrease higher expected return → higher
capital gain.
• If r increase expected capital loss will out
weight the interest earning.
• The expected return on bond would be
negative in such a case , and money would be
the preferred assets.
• “ Money held in anticipation of fall in bond
price (a rise in interest rate)”is Keynes
speculative demand for money.
DAIGRAM
 The total demand for money
• The transaction and precautionary demand for
money positively relation with income and
negative with interest rate.
• The speculation demand for money is
negatively related with interest rate.
• Md= L (Y, r)
• Md= C0 + C1Y − C2r
• C1 > 0 and C2 < 0
The effect of an increase in Money supply
• The money demand function is downward sloping
• An increase in income shift the curve to the right, for
a given interest rate money demand increase with
income.
• MS increases so MS> MD
• Peoples attempt to decrease their money holdings by
buying bonds.
• Increase the demand for bonds decrease interest
rate and suppliers of bonds offer to sell their bonds.
• So decrease interest rate demand for money
increases and new equilibrium is reached at interest
rate at r1.
 Money Market Equilibrium: The LM Curve
• Construction of LM Curve
• Md= C0 + C1Y − C2r
• The LM scheduled equation can be written as
• Ms = Md= C0 + C1Y − C2r
• In figure (a) three separate demand for money
schedules are drawn when income increases
Md shift to the right. When Md intersect Ms
line this represents equilibrium for money
market.
Factors that determines the slope of the LM Schedule
• Increase in income ∆ Y effect on money demand
equal to (C1 ∆Y)
• C1 is the parameter given the increase in money
demand per unit increase in income.
• The higher the value of C1, the larger the increase
in money demand. Hence, upward adjustment in
the interest rate to equilibrate Md and MS.
• But it is important that how elastic money
demand is with respect to changes in the rate of
interest.
• The interest elasticity of money demand
depends on the value of C2. (− C2= ∆Md/∆ r)
 (a) Low Interest Elasticity of Money Demand
(b) High interest elasticity of money demand
• Panel (a) Money demand curve is steep.
• Large change in interest rate not very much
change in money demand.
• Increase in income increase transaction demand
for money by C1 (Y1 − Y0) and C2 (Y2 − Y1).
• A given increase in the interest rate will not
reduce money demand by much (C2 is smaller).
• The interest rate will have to rise by a large
amount to reduce money demand back to the
fixed MS0.
• Panel (b) Money demand is highly interest
elastic. Here the money demand is quit flat.
• A small drop in the interest rate, increase
money demand significantly.
• Factors that shift the LM Schedule
• (1) Changes in Money Supply
• (2) Shift in the Money Demand Function
• (1) Changes in Money Supply
• MS0 = C0 + C1Y − C2r
• solving for interest rate
• LM: r = c0/c2 − 1/c2 (MS0) + c1Y/c2
• When LM is plotted, the intercept contains the
money supply. So any time the money supply
changes the intercept will change and the LM
curve will shift.
• MS increase LM will shift down.
• An increase in the money supply reduces the
interest rate to r1 for a given level of income
Y0.
• With fixed income, higher MS to be equal to
Md, the interest rate must be lower to
increase the speculative and transaction
demand for money.
(2) Shifts in the Money Demand Function
• Md0(Y0) to Md1(Y0) change. At unchanged
level of income equilibrium in the market
requires an increase in interest rate at r1.
• Maintaining equilibrium in the money market
at ro after the shift in the money demand
curve would require a fall in income to the
level below y0 at point c.
 Factors that shift the LM Curve
• Any change that reduce the real money supply
relative to real money demand will increase the
real interest rate that clears the assets market
and cause LM curve to shift up and to the left.
• Similarly for constant output anything that
raises real money supply relative to real money
demand will reduce the real interest rate that
clears the asset market and shift the LM curve
down and to the right.
 Factors that shift the LM Curve
• Demand for money increase the interest rate increase
and LM shift left
• Nominal money supply (LM shift down and to the right)
real money supply increases, lower the interest rate
• Price level (up and to the left) real money supply falls,
raising the real interest rate
• Expected inflation (down and to the right) demand for
money falls, lower the interest rate
• Nominal interest rate on money (up and to the left)
demand for money increases, raising the real interest
rate.
 The IS cure: Equilibrium in the goods market
• Good market equilibrium: when desired
investment and desired national saving are equal.
OR
• when the aggregate quantity of goods supplied
equals the aggregate quantity of goods
demanded.
• IS curve for any economy, with output on the
horizontal axis and real interest rate on vertical
axis. For any level of output the IS curve shows
the real interest rate that clears the goods market.
 Product Market Equilibrium: the IS curve
The condition for equilibrium in the product market

• Y= C+I+G (a)
• I+G= S+T (b)
• Interest rate and income combination
(equilibrium for the product market)
• I(r) = S(y)
• We find combination of the interest rate and
income that equate investment with saving.
 Construction of IS curve
(a)Investment and Saving Schedules
 Construction of IS curve

• Higher value of r1, the investment will be I1

and saving must be s1. saving level is
generated by income y1. this is a point on the
IS curve will be at r1 and y1.
 Factors that determine the slope of the IS
schedule
• (1) Investment Function
• (2) Saving Function
• Steepness of the IS curve is a factor that
determine the relative effectiveness of monetary
and fiscal stabilization policies.
• In constructing the IS curve, we consider how
investment changes with interest rate and then
at the required change in income to move saving
to equal the new investment level.
• Lower interest rate equilibrium in the product
market requires higher income levels (IS curve
relatively flat). Or slightly increased income
level ( the IS curve will steep).
• (1) the slope of the IS curve related to the
slope of the investment function.
• In figure (a) schedule I is very steep ( the
interest elasticity of investment demand is
low). The IS curve is steep in this case , lower
levels of the interest rate correspond to only
slightly higher levels of income.
• On the other hand, the schedule I’ (Flatter) is more
sensitive to the movement of interest rate (the
interest elasticity of investment demand is high).
• At r2 the investment will be I’2 and the level of
income is Y’2 at point c.
• Saving must increase to S’2 and this requires
income Y’2.
• So saving must increase greatest amount than
investment is interest elastic and large saving
increase, income must increase by more.
• IS curve (flatter) if investment will more sensitive
with interest rate.
• (2) the second factor affecting the slope of the
IS curve is the saving function.
• The higher the MPS, the saving curve is
steeper, the IS curve will be relatively steeper.
• Higher the MPS, the steeper the saving
function (saving increase by more per unit of
income).
• If MPS is high, the smaller increase in income.
• Decrease in interest rate the income would
have to be increased smaller with higher MPS.
 Factors that shift the IS schedule
• IS shift when autonomous expenditures change (T, I and G).
• With the government sector in the model the product market
is given by
• I(r) + G = S(Y − T)+ T
 (1) Changes in Government spending

• Initially interest rate is r0 and income is y0 and IS

curve is IS0. Investment plus government spending
will be (I0 + G0).
• In panel (b) an income level Y0 generates saving plus
taxes just equal to this amount of government
spending plus investment (S0+T0= I0 +G0).
• Now G increases, shift (G1 +I0) to the right at a given
interest rate.
• Equilibrium in the product market requires an equally
higher level of (S1 +T0). And (S1 +T0) will be
forthcoming by Y1.
• Thus r0 requires Y1 when G increases. When G
increases IS curve shift right, at r0 equilibrium
is at point B on Y1.
• So distance (A−B) indicates that increase in
income required to generate new savings
equal to increase G.
• Increase in S per unit increase in Y … MPS(1−b)
• So the required increase in income will be ∆ G
[1/1−b ]
• ∆G= ∆S = (1−b) ∆Y|r0
• ∆G I/1−b = ∆Y |r0
• After tax increase,
equilibrium in the
product market is at r0.
• No change in
investment and govt.
• With tax increases ,
saving plus taxes to be
unchanged b/c increase
in taxes be exactly
balanced by decline in
saving.
• IS shift left at income Y1.
• Saving and income must be lower.
• The new level of income required for product
market equilibrium at Y1.
• In crease in taxes shift IS curve to the left and
required lower income Y1.
• Increase in taxes by exactly balanced by a
decline in saving.
• 0= ∆S +∆T
• We can express the change in saving as:
• ∆S= (1−b) ∆(Y−T) = (1−b) ∆Y –( 1−b) ∆T
• 0= ∆S +∆T
• (1−b) ∆Y –( 1−b) ∆T+∆T=0
• (1−b) ∆Y−∆T+ b ∆T+∆T= 0
• (1−b) ∆Y+ b ∆T=0
• (1−b) ∆Y = − b ∆T
• ∆Y│r0 = −b/1−b ∆T
•  
 Factors that shifts the IS curve
• Expected future output ( up to the right) desired
saving falls raising the real interest rate
• Wealth (up to the right)
• Government purchase (up to the right)
• Taxes (no change or down and to the left)
increase saving and fall the real interest rate
• MPK (Up and to the right) desired investment
increase, raising the real interest rate
• Effective tax rate on capital (Down and to the left)
desired investment fall, lower the real interest rate.
 The IS and LM curve combined
• A & B point above LM curve shows excess supply
of money. At point A & B the interest rate is too
high. MS>MD, so downward pressure on r.
• Point C & D, MD>MS upward pressure on r.
• For IS curve point B& C. Output >Aggregate
demand. Saving and Tax > Investment & Govt
there would be downward pressure on output.
Point A& D indicate excess demand for output,
there would be upward pressure on output.