Money in The

Keynesian System
Dipayan Debnath
Roll no:2144003
Interest Rates and Aggregate Demand
The effects on aggregate demand and equilibrium income as a result of a change in the interest rate are illustrated
in Figure 1. Initially, we assume that the economy is in equilibrium at Yo with aggregate demand at Eg equal to
(C+ lo + Go), corresponding to an interest rate of ro. A decline in the interest rate to rj shifts the aggregate
demand curve up to E1, equal to (C +I1 + G0). This shift represents the combined effects of the interest rate on
business investment, residential construction investment, consumer expenditures on durable goods, and state and
local government investment spending. Equilibrium income rises to Y1. One important factor determining the
change in equilibrium income (Y1 -Yo) that will occur for a given change in the interest rate is the size of the
shift in aggregate demand caused by the change in the interest rate. The more sensitive the components is a ome
of aggregate demand are to interest-rate changes, the larger will be the shift in the aggregate demand function in
Figure 1 and the greater the effect on equilibrium income. The interest sensitivity of aggregate demand will
therefore be important in determining how effective monetary policy will be in affecting equilibrium income.
Figure la illustrates the idea that investment is negatively related to the interest rate. At interest rate ro, investment
is lo at point A on the investment schedule. If the interest rate decreases to r1, investment increases to I1 at point
B. Looking at Figure 1b, because investment is a component of aggregate expenditures, the expenditure schedule
shifts up, from equilibrium point A to equilibrium point B, and equilibrium income increases from Yo to Y.
Effects of a Decrease in the Interest Rate on
Investment and Equilibrium Income

Figure-1 Figure-2
Interest Rate
Within this simplified framework, Keynes considers the way in which individuals allocate their
financial wealth between the two assets, money (M) and bonds (B). At a point in time, wealth (Wh)
is fixed at some level, and because bonds and money are the only stores of wealth, we have { Wh
=B+ M }...(1). The equilibrium interest rate on
bonds is that rate at which the demand for bonds is equal to the existing stock of bonds. It might
seem most natural to develop a theory of the equilibrium interest rate by studying the factors that
directly determine the supply of and demand for bonds. Keynes did not proceed in this manner. Note
that given equation (1), there is only one independent portfolio decision, the split between money
and bonds. If, for an individual, wealth is equal to $50,000, the decision to hold $10,000 in the form
of money implicitly determines that bond holdings will be the remainder, $40,000. In terms of
equilibrium positions, this means that a person who is satisfied with the level of money holdings
relative to total wealth is, by definition [equation (1)], satisfied with the bond holdings; this person is
at the optimal split of wealth between the two stores of value. To say, for example, that the demand
for money exceeds the supply is to say, in the aggregate, that the public is trying to increase the
proportion of wealth held in the form of money. This is equivalent to saying that the supply of bonds
exceeds the demand; the public is trying to reduce the proportion of wealth held as bonds.
Consequently, there are two equivalent ways to describe the equilibrium interest rate: as the rate that
equates the supply of and demand for bonds or, alternatively, as the rate that equates the supply of
money with the demand for money. Equilibrium in one market implies equilibrium in the other.
Keynes chose the latter of these perspectives because he wished to emphasize the relationship
between money and the interest rate. This Keynesian view of interest rate determination is illustrated
in Figure 2. The money sup ply is assumed to be fixed exogenously by the central bank at M.
The Equilibrium interest rate is r0 the rate at which money demand given by the money demand schedule Md in the
graph is just equal to the fixed money supply .
 Money Demand
Transactions Demand :The first motive is the transactions motive. Money is a medium of exchange, and indi viduals hold money for use in transactions.
Money bridges the gap between the receint of income and expenditures. The amount of money held for transactions would varv positively with the volume of
transactions in which the individual engaged. Income is assumed to be a good measure of the volume of transactions, and thus the transactions demand for
money is assumed to depend positively on income. Money received in one transaction can be used to buy bonds, which can then be sold to get money again
when the time came for an expenditure. The gain from doing so is the interest earned for the time the bonds were held. Brokerage tees involved in buying
bonds and the inconveniences of a great number of such transactions would make it unprofitable to purchase bonds for small amounts to be held for short
periods. Some money would be held for transactions. Still, there is room to economize on transaction balances by such bond purchases. Because the return to
be gained is interest earnings on bonds, we would expect the incentive to economize on transaction balances to increase as the interest rate increases.
Consequently, in addition to depending positively on income, the transactions demand for money would be expected to be negatively related to the rate of
interest. Keynes did not emphasize the interest rate when discussing the transactions motive for holding money, but it has proved to be important, especially
for the business sector. Firms with a high volume of transactions can, by cash management practices, reduce their average money holdings. The incentive to
make the expenditures required for cash management depends on the rate of interest. Precautionary Demand :Keynes believed that, beyond money held for
planned transactions, additional money balances were held in case of unexpected expenditures such as medical or repair bills. Keynes termed money held for
this motive the precautionary demand for money. He believed that the amount held for this purpose depends positively on income. Again, the interest rate
might be a factor if people tended to economize on the amount of money held for the precautionary motive as interest rates rose. Because the motives for
holding precautionary balances are similar to those for transactions demand, we simplify our discussion here by subsuming the precautionary demand under
the trans actions demand category, transactions being expected or unexpected ones. Speculative Demand: The final motive for holding money that Keynes
considered was the speculative motive. Keynes began by asking why an individual would hold any money above the Needed for the transactions and
precautionary motives when bonds interest and money does not.
Individual and aggregate speculative demand schedules for money
The expected returns on the two assets can be expressed as follows:
Return on money=0
• Ecpected returns on bonds=interest earnings(=r)

The return on money is zero because it earns no interest and because it’s value is not subject
to Capital gains or losses as the interest rate changesThe bond will pay an interest rate of
r.The expected return on bonds will equal this interest return + or minus and expected capital
gain or loss .For reasons just discussed an investor who expected interest rates to fall would
expect a capital gain and one who expected interest rates to rise food expect a capital
loss .This uncertainty about the Future course of interest rates is crucial to calcium analysis .
For the individual investors ,the demand curve for speculative balances is shown in
figure.Here M2 represents the speculative demand for money by the i th individual and M1 is
the persons transactions demand. we have then
M1+M2=Mi and Mi+Bi=Whi
Where Mi,Bi,and Whi are The individuals total money Holdings Bond holdings and wealth
respectively .
The Total Demand for Money Equilibrium in Money
Market
• We have looked at the three motives for holding money in
the Keynesian system and can now put these together to
construct the total money demand function. The trang.
actions demand and the precautionary demand vary
positively with income and nega. tively with the interest
rate. The speculative demand for money is negatively
related to the interest rate. Taking those factors together, we
can write total money demand as M = L(Y,r) .
• where Y is income and r is the interest rate. A rise in income
increases money demand: a rise in the interest rate
decreases money demand. In the following analy. sis, we
sometimes make the simplifying assumption that the money
demand function is linear:
Thank you