Monetary Theory-the Keynesian

model

1
 Onset of the Great Depression
• In 1929, unemployment was around 3%. In 1933, it was 25%,
with 1 out of every 4 people out of work.
• Unemployment remained at over 10% throughout the decade.
• Real gross national product fell by 30% between 1929 and
1933 and did not reach the 1929 level again until 1939
• The average family income dropped by 40% during the Great
Depression.
• More than $1 billion in bank deposits were lost due to bank
closings.
• The worst years of the Great Depression were 1932 and 1933.
• Around 300,000 companies went out of business.
• Hundreds of thousands of families could not pay their
mortgages and were evicted from their homes.
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 John Maynard Keynes and “ The General
Theory of Employment, interest and money”
• In the wake of the great financial crash of 1929, as the economy plunged into
crisis, the economy went down and did not come up again by itself. It stayed
down. The recession became depression, yet there was no restoration of
growth.
• There didn’t seem to be any mechanism within the Classical Model that
could automatically brought the economy back to full employment level.
• The classical economists of the day like Lionel Robbins and A. C. Pigou just
kept insisting for wage reductions but it did little to solve the problem of
prolonged depression.
• In 1936, the British economist John Maynard Keynes published his book “ The
General Theory of Employment, Interest and Money” that revolutionize the
economic thinking.
• Keynes replaced the classical model with his own version of how the macro
economy works.

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Keynes Major Criticism on Classical Model
I. Potential output is not equal to actual output.
Y(A)=Y(F)

II. Although equilibrating tendencies exist in the economy but Classical theory ignores the
problems of imperfect markets . Prices and Wages are not flexible in the short run .
III. Transactionary motive is not the only purpose of holding money. Money is not neutral
and V is not constant
IV. Unlike Classical’s claim that interest rate does not perform the function of always
equilibrating investment=Savings and AD=AS because it is not the major determinant of
S and I. Thus AD can be unequal to Y and saving can be unequal to Investments .
V. Money is not the only determinant of AD . Both money market and goods market
equilibriums determine the AD.
VI. Autonomous shifts in AD determines the actual output contrary to ‘supply creates its
own demand’
VII.Instead of a passive role of the government, Keynes advocated an active role of the
government by employing stabilization policies to bring output to its full employment
level-They can take a long time to bring output to its potential level.-”In the long run we
are all dead’

4
 Keynesian Theories of Money Demand
Keynes’s Liquidity Preference Theory
• Distinguishes between real and nominal
quantities of money (Md, Md/P)
• Why do individuals hold money? Three
Motives
– Transactions motive
– Precautionary motive
– Speculative motive
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 Liquidity Preference Theory
• Transactions Motive—yields transactions demand for money
• Precautionary Motive—yielding precautionary demand for
money that people hold money as a cushion against unexpected
wants

• Keynes accepted the quantity theory view that both transactions

and precautionary component are proportional to income

• Speculative Motive—yielding the speculative demand for money that

people hold money to avoid capital gains and losses.
• Speculative money demand is a function of market interest rate on non
monetary assets like bonds etc

6
 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
• Wealth = M + B

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 Speculative Demand

People decide to hold money

r instead of bonds when interest
rates get so low that they cannot
possibly go lower. The move to
money to avoid capital losses.
There is a rational motive for
hoarding money!!!

Md
r0

M
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Total Money demand is the sum of Md(T)+Md(P)+Md(S)
According to Keynes both transaction and People decide to hold money instead of
precautionary demand for money are a function of bonds when interest rates get so low that
real income (Y) and are not affected by changes in
interest rate (r) they cannot possibly go lower. The move
to money to avoid capital losses.
• Liquidity Preference Theory

r0
r0
r1
r1

Md(s)0 Md(s)1
Md(p+t+s)0 Md(p+t+s)1

M P
d
 L (r ,Y ) 9
 Money supply
r
M P
s
The supply of interest
real money rate
balances
is fixed:

M P M P
s

M/P
M P
real money
balances

10
 Money demand
r
M P
s
Demand for interest
real money rate
balances:

M P
d
 L (r )

L (r )

M/P
M P
real money
balances

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Equilibrium in Money Market determines the
interest rate
r
The interest interest M P
s

rate adjusts rate

to equate the
supply and
demand for
money: r1

M P  L (r ) L (r )

M/P
M P
real money
balances

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Liquidity Effect- Effect of ∆ MS on Money Market
Equilibrium:
If MS increases at the market interest rate MS>MD-people will buy more
bonds-demand for B will increase will increase their Price and the market
interest rate will eventually decrease

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Real Balance Effect- Effect of ∆ P on Money
Market Equilibrium :
When P increases –real money will decrease MS<MD-people
will sell B for more money –P of bonds will decrease and
market interest rate will increase

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Effect of ∆ MD on Money Market
Equilibrium

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 The LM curve
Money demand function:

M P
d
 L (r ,Y )

The LM curve is a graph of all combinations of r and

Y that equate the supply and demand for real
money balances.
The equation for the LM curve is:
M P  L (r ,Y )

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 Deriving the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM

r2 r2

L (r , Y2 )
r1 r1
L (r , Y1 )
M1 M/P Y1 Y2 Y
P
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 Why the LM curve is upward sloping

• An increase in income raises money demand.

• Since the supply of real balances is fixed, there
is now excess demand in the money market at
the initial interest rate.
• The interest rate must rise to restore
equilibrium in the money market.

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 Shifts in the LM curve
(a) The market for
real money balances(∆MS, ∆ Md (b) The LM curve will shift
and ∆ P) vertically upward
r r
LM2

LM1
r2 r2

r1 r1
L ( r , Y1 )

M2 M1 M/P Y1 Y
P P
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Impact of change in the Price level on the LM
curve (P )

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Impact of change in the Md on the LM curve(
Md )

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Putting the Three Motives Together
Md
 f (i,Y ) where the demand for real money balances is
P
negatively related to the interest rate i,
and positively related to real income Y
Rewriting
P 1

M d f (i,Y )
Multiply both sides by Y and replacing M d with M
PY Y
V 
M f (i,Y )
Velocity is not constant:
The procyclical movement of interest rates should induce procyclical
movements in velocity.
Velocity will change as expectations about future normal levels of interest rates
change
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 Portfolio Theories of Money Demand
• Theory of Portfolio Choice and Keynesian
Liquidity Preference
– The theory of portfolio choice can justify the
conclusion from the Keynesian liquidity preference
function that the demand for real money balances is
positively related to income and negatively related
to the nominal interest rate

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Portfolio Theories of Money Demand (cont’d)

• Other Factors That Affect the Demand for Money:

– Wealth
– Risk
– Liquidity of other assets

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Interest Rates and Money Demand
• We have established that if interest rates do not affect the
demand for money, velocity is more likely to be constant—or
at least predictable—so that the quantity theory view that
aggregate spending is determined by the quantity of money is
more likely to be true

• However, the more sensitive the demand for money is to

interest rates, the more unpredictable velocity will be, and
the less clear the link between the money supply and
aggregate spending will be

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 Stability of Money Demand
• If the money demand function is unstable and undergoes
substantial, unpredictable shifts as Keynes believed, then
velocity is unpredictable, and the quantity of money may not
be tightly linked to aggregate spending, as it is in the quantity
theory

• The stability of the money demand function is also crucial to

whether the Federal Reserve should target interest rates or
the money supply

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Aggregate Demand Schedule in the Keynesian Model

• Aggregate expenditures schedule:

– A schedule that represents total desired expenditures
by all the relevant sectors of the economy at each
and every level of real national income.
• Aggregate net autonomous expenditures:
– The sum of autonomous consumption, autonomous
investment, autonomous government spending, and
autonomous export spending, all of which are
independent of the level of national income in the
basic Keynesian model.
23–27
Deriving the Aggregate Expenditures Schedule

Figure 23–7

23–28
 The 45-Degree Line

A line that cuts in half the

90-degree angle of the
coordinate axes on a
diagram relating real
income to aggregate
desired expenditures;
every point on the 45-
degree line could, in
principle, be a point of
equilibrium at which real
income equals aggregate
desired expenditures.

Figure 23–8

23–29
 Multiplier Effects
• Multiplier effect:
– The ratio of a change in the equilibrium real
income to an increase in autonomous net
aggregate expenditures.
– When the aggregate expenditures schedule shifts
vertically, the equilibrium level of national income
changes by a multiple of the amount of the shift.

23–30
 (b)From The Keynesian Cross
Deriving the IS curve model

E E =Y
E =C +I (r2 )+G
r  I E =C +I (r1 )+G

I r  I  E

 Y
S1 S2 Y1 Y2 Y
r r

r1 r1

r2 r2
I (r ) IS
S, I Y
Y1 Y2
(a) From The Loanable
Funds model 31
 Why the IS curve is negatively sloped

• A fall in the interest rate motivates firms to

increase investment spending, which drives up
total planned spending (E ).
• To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y )
must increase.

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• IS curve is the locus of all combinations of r and real
income, y, when goods market is in equilibrium.
• The name was given in 1937 by John Hicks, who first
derived the schedule by assuming a simple economy
with no government sector.
• Because income is equal to desired expenditures all
along the IS curve schedule, it also true that with no
government, saving “leakages” from income-
expenditure flow equal investment “reinjections”.
Therefore I=S hence the term IS
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 Shifting the IS curve: G
E E =Y E =C +I (r )+G
At any value of r, G 1 2

 E  Y E =C +I (r1 )+G1
…so the IS curve shifts
to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals
1 Y
Y  G IS2
1 MPC IS1
Y1 Y2 Y

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 IS-LM Equilibrium
• The IS schedule represents all real income-interest rate
combinations for which real income is in equilibrium
• LM schedule represents all real income-interest rate combinations
for which the market for real money balances is in equilibrium
• The IS-LM schedules help in simultaneously looking at the impact
of change in equilibrium in any one market on the equilibrium
level of r and y where both markets will be at equilibrium
• Combining the two schedules on one diagram, we can find the
single combination of real income and the interest rate that
achieves quilibrium real income and equilibrium in the market for
real money balances.
• This combination is known as IS-LM equilibrium

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 The short-run equilibrium
The short-run equilibrium is the r
combination of r and Y that LM
simultaneously satisfies the
equilibrium conditions in the
goods & money markets:

Y  C (Y  T )  I (r )  G IS
M P  L (r ,Y ) Y
Equilibrium
interest Equilibrium
rate level of
income
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 The IS-LM equilibrium and disequilibrium
• At A and D goods market is in
: equlibrium but money market is not so r
interest rate will adjust to equate Ms and
Md .
LM
• At points B and C Money market is in
r2 A B
equilibrium but goods market is not so
actual output will adjust to changes in r0 E
AD
• Point A is above LM (MS>MD)-r will fall C D
towards r0 causing movement along the r1
IS curve IS
• Point B is above IS curve (Y>AD) and (I>S) Y2
Y
Y1 Y0
thus undesired output or investment
expenditure will adjust (decrease) . As
real income falls demand for real money
balances will decrease causing interest
rate to fall in the money market –
movement along the LM curve towards E 37