Keynesian IS-LMProblems with the Income-Expenditure ModelMoney in the Keynesian ModelLiquidity Preference TheoryLiquidity Preference TheorySpeculative Demand (1)Speculative Demand (2)Speculative Demand (3)Precautionary DemandAmbiguity in the Money MarketSidenote: Hicks’ Little ApparatusKeynesian “Money Market”Hicks’ Interpretation: LM CurveLM Curve Slopes Upward Because...LM Curve Slopes Upward Because...LM and the Money MarketChanges in Money SupplyCapital MarketIS CurveIS Curve Slopes Downward Because...Money and InvestmentIS-LMMoney-Income TransmissionNotes on IS-LMLinearized IS-LMLinearized IS-LMClassical Model? (=0)Keynesian ISKeynesian IS--LMLMThe Keynesian System (II):Money, Interest, and Income2Problems with the Problems with the IncomeIncome--Expenditure ModelExpenditure Modelz What about prices? – Don’t they change when AS and AD conditions change?– Don’t they have an influence?z Are firms really indifferent to changes in the real wage rate?z These issues remain to be addressed...3Money in the Keynesian ModelMoney in the Keynesian Modelz Recall the classical model:– Transactions motive: people hold money only to make transactions– Rejects the store of value theory of the mercantilists, arguing that:• Money bears no interest, and• A rational person would not forego a positive return by holding money unless he/she planned to make a transaction.– People do not hoard money.4Liquidity Preference TheoryLiquidity Preference Theoryz Money is:1. A Medium of Exchange2. A Store of Value3. A Unit of Accountz The first two create demands for money.5Liquidity Preference TheoryLiquidity Preference Theoryz Transactions Motive—yields transactions demand for moneyz Store of Value—yields:– Precautionary Motive—yielding precautionary demand for money– Speculative Motive—yielding the speculative demand for moneyzzThere are reasons why someone might There are reasons why someone might rationally hoard money!rationally hoard money!6Speculative Demand (1)Speculative Demand (1)z Keynes considers a portfolio of financial assets.z All financial assets can be considered as money or bonds:– Money (M): yields no return– Bonds (B): yield a returnz Wh = M + B7Speculative Demand (2)Speculative Demand (2)z Example—Perpetuity (a bond that never matures):– Bond is issued at $1000– Coupon rate is $50 Æ 50/1000=5%– Later, market interest double to 10%– How much can you sell the bond for?– Ans: $500 because 50/500=10%z When interest rates rise, bond prices fall Æ capital losses!8Speculative Demand (3)Speculative Demand (3)People decide to hold money instead of bonds when interest rates get so low that they cannot possibly go lower. The move to money to avoid capital losses.rThere is a rational motive for hoarding money!!!Lp=Lp(r)(-)Mdr0As interest rates fall, BdÆ 0 and MdÆ ∞.M9Precautionary DemandPrecautionary Demandz People hold money (“precautionary balances”) for unforeseeable expenses.z These holdings (“balances”) tend to:– Rise with income, and – Fall with interest rates.z Lp= Lp(Y,r)(+) (-)10Ambiguity in the Money MarketAmbiguity in the Money Marketz In the classical model:– Ms= M0(exogenous)– Md= Md(Y)– We used these relationships to create the AD curve.z In Keynes’ model: – Ms= M0(exogenous)– Md= L(Y,r)– Ms= Md– M0= L(Y,r) is the money market outcome.11SidenoteSidenote: Hicks’ Little Apparatus: Hicks’ Little Apparatusz Sir John Hicks, 1939, “Mr Keynes and the Classics, a Suggested Interpretation”z Introduces the IS-LM Model as a way of making sense of Keynes’ General Theory.12Keynesian “Money Market”Keynesian “Money Market”z M0= L(Y,r) is the equilibrium in the money market.z There is not one single variable that can change to clear the market. There are two!z The “money market” cannot tell us alone what the supply and demand for money will be.z Money is not dichotomous.13Hicks’ Interpretation: LM CurveHicks’ Interpretation: LM CurveLM Curve (L=M): all those combinations of real interest rates and income which bring the money supply equal to money demand.rLMY14LM Curve Slopes Upward Because...LM Curve Slopes Upward Because...z Assumes Ms= M0(exogenous)z If Y increases, transactions and precautionary demand increase.– There will be excess demand in the money markets– Interest rates will be driven upwardz So Y↑→ r↑, and the LM Curve slopes upward.MrMd(Y0)Md(Y1)Msr1r015LM Curve Slopes Upward Because...LM Curve Slopes Upward Because...Liquidity Preference is:L = L(Y,r)Money Supply is:Ms= M0= MMs= MdimpliesM = L(Y,r) Æ LM CurveDifferentiating:0)()(>−+−=∂∂∂∂−=rLYLdYdr16LM and the Money MarketLM and the Money MarketMMsYr0r1rrMd(Y1)Md(Y0)Md(Y2)Y0Y1Y2LM17Changes in Money SupplyChanges in Money SupplyMrMdMs↓ MsMs↑r*Ms↓Ms↑18Capital MarketCapital Marketz Investment I = I(r,E) = I(r)z But Saving S = S(Y) or S(Yd)z So there is not a single “price variable” to clear the capital market!z I(r) = S(Y) Æ IS Curve: IS = IS(Y,r)z IS: all those combinations of Y and r which make the “capital market” clear.z Equivalently, IS is all those combinations of Y and r for which supply = demand in the loanable funds market.z Thus the real sector cannot be resolved without considering money market outcomes.– Money is NOT dichotomous.19IS CurveIS CurverISSlopes downward becauser↑→ I↓→ Y↓Y20IS Curve Slopes Downward Because...IS Curve Slopes Downward Because...Recall that:I + T = S + GorI(r) + T0= S(Y) + G0Differentiate implicitly with respect to Y and r:0)()(<−+==drdIdYdsdYdr21r SIIr0r1r2I0I1I2YISr0r1r2Y0Y1Y2YI2= S2I1= S1I0= S0Y2Y1Y0S22Money and InvestmentMoney and InvestmentThe interest rate is determined in the money market. Decision makers in firms compare this rate to the MEC and make the decision regarding investment.IrrIMMsr*MdM* I*The real and monetary sectors are linked. Money matters!23ISIS--LMLMISLMYrr*Y* Note that the real and monetary sectors of the economy are resolved together. Money matters to real sector outcomes.  There is no dichotomy.24MoneyMoney--Income TransmissionIncome TransmissionThe Keynes Effect (Money Income Transmission Mechanism):↑→↑→⎭⎬⎫⎩⎨⎧↑↑→↓→↑→↑→↑ PADCIrPBMdurablesBds• Money is not neutral (in the short run), and there is no dichotomy.• Some modern Keynesians argue for long-run neutrality, but short-run nonneutrality.• Changes in the money supply affect the real sector