KENYATTAUNI

VERSI
TY
SCHOOLOFECONOMI
CS
DEPARTMENTOFECONOMI
CTHEORY
LECTURER:MUTHUIJ.N.

EET201:MACROECONOMI
CTHEORYI
I

CHAPTERONE
I
NTRODUCTI
ON
 The decade of1970’
s and t
he ear
ly 1980’
s was mar
ked by sever
al
macr
oeconomi
cpr
obl
emsamongwhi
chi
ncl
udest
heoi
lshockasOPECoi
l
car
telr
aisedpr
ices,
leadi
ngt
oinf
lat
ionar
oundt
hewor
ldt
oint
ensi
fy.
 Sever
alcount
ri
es oft
he woul
d,i
ncl
udi
ng USA suf
fer
ed a r
ecessi
on as
mar
kedbyhi
ghunempl
oyment
.
 Sever
alt
heor
ieshavebeenadvancedt
otr
yandpr
ovi
deanswer
stot
hebasi
c
economi
cquest
ions,
whi
chi
ncl
udes:
o PostKeynesi
an
o Monet
ari
sts
o Demandsi
de
o Suppl
ysi
devi
ewsamongot
her
s.
 Someoft
hevi
ewsar
econt
radi
ctor
ywhi
leot
her
sar
ecompl
ement
ary.Our
mai
nai
mint
hiscour
sei
stoexpl
oret
hedi
ff
er
 r
enteconomi
cideast
hathavebeendevel
opedi
nor
dert
odealwi
thand
mani
pul
atepr
obl
emsaf
fect
ingt
heeconomi
esoft
hewoul
d.

REVI
SIONOFSOMEBASI
CCONCEPRTS
1.Quest
ion:howdoesmi
croeconomi
csdi
ff
erf
rom macr
oeconomi
cs?
Mi
croeconomi
cst
heor
y:
 I
nvest
igat
eshowi
ndi
vidual
sinsoci
etychooset
oal
locat
escar
cei
ncomeor
r
esour
cesamongcompet
ingwant
sorpr
oduct
ionobj
ect
ives.
 I
tal
sost
udi
esf
act
orsaf
fect
ingt
her
elat
ivepr
icesofdi
ff
erentgoodsand
f
act
orsofpr
oduct
ioni
nindi
vidualmar
ket(
e.g.t
hesuppl
yanddemandf
or
mi
l
kormot
orvehi
cle)
.

Macr
oeconomi
ctheor
y:
 On t
he ot
herhand i
s concer
ned wi
th aggr
egat
e var
iabl
es such as t
he
aggr
egat
edemandbyal
lconsumer
sforal
lgoodsandser
vicespr
oducedi
n
aneconomyoveray
earorsomeot
herper
iod.
Among t
he aggr
egat
e economi
c phenomena macr
oeconomi
c t
heor
y
consi
der
sincl
ude:
i
) I
nfl
ati
on
i
i) Thei
nter
estr
ate
i
ii
) Thegr
owt
hrat
eofi
ncome/
out
put
i
v) Ther
ateofunempl
oyment
v) Gover
nmentspendi
ng
vi
) Pr
ivat
edomest
ici
nvest
ment
vi
i) Aggr
egat
edi
sposabl
eincome
vi
ii
) Thegener
alpr
icel
evel
.
 Macr
oeconomi
ctheor
yist
heexpl
anat
ionofhow t
heaggr
egat
evar
iabl
es
suchasnat
ionalout
put
,empl
oymentandpr
icesi
nter
actandi
nter
connectt
o
pr
oducet
hest
ateofournat
ionaleconomi
csi
tuat
ion.

2
BUSI
NESSCYCLES/EQULI
BRI
UM

Ther
eexi
stt
woschool
soft
houghtwheni
tcomest
orest
orat
ionofequi
li
bri
um
Aut
omat
icanddi
scr
eti
onar
ymeasur
es
1Aut
omat
icst
abi
li
zat
ion
2.Di
scr
eti
onar
yst
abi
li
zat
ionmeasur
es
Thegover
nmenti
satl
iber
tyt
ouseei
theroft
het
wopol
ici
esi
e.Fi
scalpol
icyand
monet
arypol
icy
Fi
scalpol
icyandGoal
s
I
sanat
temptt
omani
pul
ategover
nmentexpendi
tur
eandt
axat
ionsoast
oaf
fect
aggr
egat
edemandoraggr
egat
esuppl
yinsomemannert
hatachi
evesdesi
red
macr
ogoalsuchasf
ullempl
oymentandpr
icest
abi
li
ty.

Monet
arypol
icy
I
sapol
icywhi
chaf
fect
smoneysuppl
ygr
owt
h.I
tcanbeusedt
oaf
fecti
nfl
ati
on
andempl
oyment
.

Obj
ect
ivesofmonet
arypol
icy
I
stoachi
evef
ullempl
oymentandpr
icest
abi
li
ty.
Weuset
heaggr
egat
edemandandaggr
egat
esuppl
yfr
amewor
ktoi
ll
ust
rat
ethe

3
conceptoff
ullempl
oymentandpr
icest
abi
li
ty.

Case1:
 Whent
heeconomyi
satf
ullempl
oymentl
evel
,theaggr
egat
esuppl
yof
goodsandser
viceswoul
dnotber
esponsi
vet
oincr
easei
ntheaggr
egat
e
demand.Theaggr
egat
esuppl
ycur
vewoul
dbever
ti
cal(
per
fect
lyi
nel
ast
ic)
 Asar
esul
t,ani
ncr
easei
ntheaggr
egat
edemandowi
ngt
oexpansi
onar
y
f
iscalormonet
arypol
icywoul
dbei
nfl
ati
onar
y.

Longr un
aggregate
supply

Case2:
 I
nacasewher
etheeconomyi
sresponsi
vet
oincr
easei
naggr
egat
edemand.
I
n ot
herwor
ds,t
he economy i
s notatf
ullempl
oymentl
evel
,and i
s
r
esponsi
vet
opol
icychanges.
 Att
hepoi
ntofwi
despr
eadunempl
oyment
,incr
easei
naggr
egat
edemand
woul
dnotonl
ycr
eat
eaddi
ti
onalt
oout
putbutwoul
dcausei
nfl
ati
onaswel
l.
 At
radeof
fwoul
dexi
st,i
not
herwor
ds,bet
weenchangesi
nthel
evelof

4
 out
putandempl
oymentandchangesi
nthel
evelofpr
ices.

 Anexpansi
onar
ypol
i
cyt
hati
ncr
easesADl
eadsoi
ncr
easei
nlevel
sofout
put
f
rom t
o andpr
icesf
rom t
o .

 I
not
herwor
ds,t
hel
evelofempl
oymentat i
shi
ghert
han .Associ
ated
wi
thhi
ghempl
oymentl
eveli
shi
gherpr
icel
evelorsomel
evelofi
nfl
ati
on.
 (
Mor
eaboutt
rade-
offbet
weenunempl
oymentandi
nfl
ati
onwi
llbecover
ed
l
ater
)

Useoff
iscalandmonet
aryt
ool
stosol
vemacr
oeconomi
cpr
obl
ems.
Useoff
iscalpol
icyt
ool
s.
Case1:Depr
essi
onPer
iod.
 Att
heonsetofdepr
eci
ati
on,
thegover
nmentmarat
temptt
oaf
fectaggr
egat
e
demand(
incr
ease)byacombi
nat
ionoft
axcut
sand gover
nmentspendi
ng
pr
ogr
amst
hatwoul
dincr
easenat
ionalempl
oymentandout
put
.

Case2:Per
iodofI
nfl
ati
on
 Fi
scalr
emedydur
ingi
nfl
ati
onper
iodi
stoi
ncr
easet
axesart
axr
atesi
n
combi
nat
ion wi
thr
educt
ion i
n gover
nment spendi
ng,hence r
educi
ng
aggr
egat
e spendi
ng (
demand)and choki
ng of
fbot
h pr
ivat
e and publ
ic

5
 demand.

Useofmonet
arypol
icyt
ool
s
 Monet
arypol
icyconsi
stoft
hemani
pul
ati
onofbankr
eser
vesoff
inanci
al
syst
emst
hroughal
ter
ati
oni
nthe di
scountr
ate,openmar
ketsal
es and
pur
chaseofsecur
it
ies,
andchangesi
nreser
ver
equi
rement
s.

Def
ini
ti
ons.
(
i) Bankr
eser
ves:ar
e“cashbacki
ng”ofdeposi
ts(
checki
ng,savi
ngand
ot
hert
ypesofdeposi
ts)hel
dbycommer
cialbanksandot
herf
inanci
al
i
nst
it
uti
ons.
(
ii
) Di
scountr
ate:i
sthe i
nter
estr
ate cent
ralbankchar
ges f
inanci
al
i
nst
it
uti
onsf
or“
discount
ing”pr
omi
ssor
ynot
esandt
reasur
ybi
ll
s.
(
ii
i) Openmar
ketoper
ati
ons:i
nvol
vessel
li
ngandbuyi
ngofsecur
it
ieson
t
hepr
ivat
ebondmar
ket
.Suchbuyi
ngandsel
li
ngchangest
hepr
ice
andyi
eldst
hebondsandhencet
hehol
dingsofbondsbyf
inanci
al
syst
emsandt
hepubl
ic.
(
iv) Legalr
eser
ver
equi
rement
:ist
heper
cent
ageofcashr
eser
vef
inanci
al
i
nst
it
uti
onsar
erequi
rest
ohol
dagai
nstchecki
ng,savi
ngsandot
her
t
ypesofdeposi
ts.

Reasonsf
orcont
rol
li
ngmonet
aryr
eser
ves.
 Bycont
rol
li
ngmonet
aryr
eser
ve,t
hecent
ralbankaf
fect
sthemoneysuppl
y
and\
or i
nter
est r
ates, whi
ch can change pr
ivat
e consumpt
ion and
i
nvest
ment
sexpendi
tur
e(aggr
egat
edemand)andt
husempl
oyment
,out
put
andpr
ice.

Case1:depr
essi
onper
iod
 Toi
ncr
easeaggr
egat
edemand,t
hecent
ralbankneedst
oincr
easemoney

6
 suppl
yandl
oweri
nter
estr
ate.
 Thecent
ralbankachi
evest
hisby
(
i) Lower
ing di
scountr
ates hence anabl
ing f
inanci
ali
nst
it
uti
ons t
o
acqui
re mor
ereser
vest
hatenabl
est
hem t
o expl
orel
endi
ng and
moneysuppl
ycf
eat
ion.
(
ii
) Buyi
ngsecur
it
iest
hroughopen-
mar
ketoper
ati
onsathi
gherpr
ices,
l
ower
ingt
heyi
eldsofbonds.Asar
esul
tfi
nanci
alsyst
em andt
he
publ
ichol
dlessbonds.Moneyst
ocki
ncr
easesandi
nter
estr
ates
decl
ine,
boost
ingpr
ivat
econsumpt
ionandi
nvest
mentexpendi
tur
e.
(
ii
i) Aggr
egat
edemandmayal
sobeboost
edbyl
ower
ingt
hel
egalr
eser
ve
r
equi
rementappl
iedt
ocommer
cialbanks.

Case2:i
nfl
ati
onar
yper
iods:t
heopposi
teoft
heabovewoul
dbeadopt
ed.

3.Di
scr
eti
onar
yVsAut
omat
icSt
abi
li
zat
ion
1.Fi
scalandmonet
arypol
icymaybet
ermeddi
scr
eti
onar
ypol
ici
es.Thati
s,
pol
ici
esr
equi
redi
recti
nter
vent
ionbyf
iscal
aut
hor
it
yandt
hecent
ralbank.
2.Someeconomi
stsbel
ievet
hatdi
scr
eti
onar
ypol
ici
eswoul
dwor
ktosol
ve
economi
cpr
obl
ems,
whi
leot
hereconomi
stsar
einser
iousdoubt
saboutt
he
abi
li
tyofdi
scr
eti
onar
ycont
rol
stosol
venat
ionaleconomi
cpr
obl
em.They
ar
guet
hatwhent
heeconomi
cequi
li
bri
um oft
heeconomyi
sdi
spl
aced,i
t
woul
dret
urnaut
omat
ical
lyt
oful
lempl
oymenti
nacompet
it
ivesyst
em by
mar
ketadj
ust
menti
npr
ices,
wages,
andi
nter
estr
ates.

Di
sti
nct
ionbet
weent
hevar
iousopposi
ngmacr
oeconomi
cvi
ews.
1.Cl
assi
calvi
eworneocl
assi
calvi
ew
 Ar
guet
hati
nacompet
it
ivemar
ketsyst
em,pr
ices,wagesandi
nter
estr
ates
woul
daut
omat
ical
lyadj
ustt
orest
oret
heeconomybackt
oful
lempl
oyment
l
evel
.
 They advocat
eformi
nimum gover
nmenti
nter
vent
ion,si
nce empl
oyi
ng
di
scr
eti
oni
nfi
scalandmonet
aryaf
fai
rsmi
ghtcompoundpr
obl
emsr
ather

7
 Thancur
ingt
hem.

2.Keynesi
anVi
ew
 I
nthemi
dstoft
hewor
ldwi
dedepr
essi
onoft
he1930s,JohnMaynar
d
Keynes,
aBr
it
isheconomi
st,
arguedot
her
wise.
 I
nhi
sfamousbookt
hegener
alt
heor
yofempl
oyment
,int
erestandmoney.
(
1936)
,Keynessai
dthatt
heeconomycoul
dbei
nar
ecessi
onordepr
essi
on
i
nequi
li
bri
um andt
hati
nthel
ongr
unwear
eal
ldeadanyway.
 Keynes,anear
li
erdef
enderoft
hecl
assi
calvi
ew sai
dthataspect
soft
he
cl
assi
calt
heor
y,coupl
ed wi
th cer
tai
ninst
it
uti
onalr
igi
dit
y,pr
event
ed
“
aut
omat
icf
orces”f
rom doi
ngt
hei
rwor
kint
heshor
tort
hel
ongr
un.
 Al
ongot
herpr
obl
emsi
nthecl
assi
calvi
ew,Keynespoi
ntedt
ouni
on and
monopol
y power and most i
mpor
tant t
o cer
tai
nfact
ors concer
ning
i
nvest
mentdemandandmoneydemandasf
atal
lyi
nhi
bit
ingt
heaut
omat
ic
mechani
sm assumedbyt
hecl
assi
cal
wri
ter
s.
 Keynesadvocat
edf
ordi
scr
eti
onar
yfi
scalpol
ici
esgi
vent
hef
ail
ureoft
he
aut
omat
icf
orcesasacount
ercycl
icaldevi
cet
oopposeadver
set
rendsi
n
busi
nesscycl
es.
 I
nper
iodofmassi
veunempl
oymentanddepr
essi
on,expansi
onar
yfi
scal
pol
icywasr
equi
redbygover
nmentt
osol
vet
hepr
obl
em i
nlesst
imet
han
“
aut
omat
icf
orces”evercoul
d.
 Cont
ract
ionar
yfi
scalpol
icywasr
equi
redi
nper
iodofi
nfl
ati
on.
 The Key
nesi
an t
heor
ysur
vived t
he Gr
eatDepr
essi
on oft
he 1930sand
became t
he domi
nant vi
ew hel
d by pr
ofessi
onal economi
sts and
pol
icymaker
swel
li
ntot
he1960s(
longaf
terKeynes’
deat
hin1946)

3)Themonet
ari
stvi
ew
 I
samodi
fi
edver
sionoft
hecl
assi
cal“
aut
omat
icf
orces”t
hatwasl
edby
Mi
l
tonFr
iedmanoft
heChi
cagoSchool
.
 Theeconomi
sts,
ledbyMi
l
tonFr
iedmanar
ecal
ledmonet
ari
sts.
 Themonet
ari
stssuppor
tthebasi
cver
sionoft
hecl
assi
calposi
ti
oni
.e.

8
 i
) Bal
ancedbudget
i
i) Mi
nimum gover
nmenti
nter
vent
ionandr
egul
ati
ons
i
ii
) And st
eady pr
edi
ctabl
e money suppl
y gr
owt
h,al
ong wi
th ot
her
pr
edi
ctabl
eeconomi
cpol
ici
es.
 I
nthei
rvi
ew,di
scr
eti
onar
ypol
ici
escr
eat
euncer
tai
ntyandhavenot
ori
ous
unpr
edi
ctabl
eef
fect
sint
heshor
trun.I
nthemonet
ari
stvi
ew,t
het
imi
ngof
pol
ici
eshasexagger
atedswi
ngsi
ninf
lat
ionr
atesandi
nthebusi
nesscycl
e.
 Ont
heposi
ti
vesi
de,
monet
ari
stsar
gue:
i
) Theaut
omat
icf
orceswi
llwor
kint
heeconomy.
i
i) Thatmuchgover
nment
al“
ti
nker
ing”pl
ust
hemassi
vegr
owt
hof
r
egul
ati
onsi
ntheeconomyshoul
dbeshar
plycur
tai
ledsi
ncei
thas
cr
eat
ed ar
ti
fi
cial “
ri
gidi
ti
es” i
n t
he economy maki
ng sel
f
adj
ust
mental
lthemor
edi
ff
icul
tand
i
ii
) Thatabal
ancedbudgett
oget
herwi
thamonet
aryr
uleconcer
ning
gr
owt
hinmoneyst
ocki
scal
ledf
or(
isnecessar
y)

THEDEMANDSI
DEVsTHESUPPLYSI
DE.
 Ther
ear
etwowayst
oanal
yzet
heaggr
egat
eeconomy.
i
) Aggr
egat
edemandanal
ysi
s
i
i) Aggr
egat
esuppl
yanal
ysi
s
 Aggr
egat
edemandanal
ysi
sconcer
nst
hecausesordet
ermi
nant
soft
he
demandf
orgoodsandser
vices.
 Bot
h post– Keynesi
ans and Monet
ari
sts have been deal
ing al
most
excl
usi
vel
ywi
th“
demandmanagement
”inmoder
nti
mes.
 ThepostKeynesi
anf
avordi
scr
eti
onar
yact
ions,especi
all
yfi
scalonest
o
ensur
eful
lempl
oymentandi
nfl
ati
on-
lessdemand.
 Themonet
ari
sts,ont
heot
herhandchoosedemandmanagementpol
ici
es
t
hatdonotmanageatal
l.
i
) Moneysuppl
yrul
es
i
i) Noni
nter
vent
ioni
ntheeconomy
i
ii
) Bal
ancebudgetet
c

9
 I
nthei
rvi
ew,
thesepol
ici
esensur
esuf
fi
cientaggr
egat
edemand.

Aggr
egat
esuppl
yanal
ysi
s
 Ont
hesuppl
ysi
de,
product
ivi
tyofl
aborandcapi
tali
semphasi
zed.
 The i
nfl
ati
on oft
he 1970s may be anal
yzed i
nter
ms ofsuppl
y-si
de
economi
cs.
 I
ntheU.
S.,
forexampl
e,l
aborpr
oduct
ivi
tygr
ewsl
owl
yovert
hedecadeoft
he
70s,
slowert
hant
her
isei
nwager
ates.
 Oner
esul
tofwagesgr
owi
ngf
ast
ert
hanout
putwasi
nfl
ati
on,asmor
e
dol
lar
schasedt
oof
ewgoodsandser
vices.
 Suppl
ysi
der
s,t
henat
tackt
hemacr
oeconomi
cpr
obl
emsofi
nfl
ati
onand
unempl
oymentby pr
oposi
ng means t
o enhance l
aborpr
oduct
ivi
ty and
capi
tali
nvest
ment
.
 Taxcut
,der
egul
ati
ngofi
ndust
ry,r
educi
ngunr
eal
ist
icpol
lut
ionst
andar
ds
andbudgetbal
ancear
eal
lpar
toft
hesuppl
ysi
derpol
icyki
t.
 Thepol
ici
eswoul
dincr
easesavi
ngsandcapi
talf
ormat
ion,woul
dreduce
sol
idwel
far
esubsi
dies,andwoul
dst
imul
atepr
ivat
elabort
rai
ningpr
ogr
ams
andwor
kef
for
ts.
 The suppl
y si
de pol
icy pr
ogr
am doesn’
tconsi
der aggr
egat
e demand
pr
obl
emsasuni
mpor
tant
,inst
eadsuppl
y-si
der
sbel
ievet
hatpr
oduct
ivi
tyand
capi
talf
ormat
ionhavebeenshor
tchangedanddi
scour
agedi
nthequestt
o
cont
rolaggr
egat
edemand.
 I
tiswor
thnot
ingt
hatsomepost
-Keynesi
anar
esuppl
y-si
deadvocat
es,
al
thought
hesuppl
ysi
deemphasi
sis,f
orsomewhatobvi
ousr
easons,most
of
tenassoci
atedwi
tht
hemonet
ari
stt
heor
eti
calandpol
icyper
spect
ive.

Whoar
ethesuppl
ysi
der
s?
 Thef
ir
stsuppl
ysi
der
swer
ethecl
assi
caleconomi
sts–Adam Smi
th,Davi
d
Ri
car
doandJohnSt
uar
tMi
ll
.
 Theyal
lemphasi
zedt
hatt
heweal
thofanynat
ionwasf
ir
standf
oremosta

10
 pr
oductofl
aborski
llandpr
oduct
ivi
tycoupl
edwi
tht
hequant
it
yandqual
it
y
ofcapi
talt
hatl
aborhadt
owor
kwi
th.
 I
nthechapt
ert
hatwi
llf
oll
ow,
weshal
llookatt
heessent
ial
soft
hecl
assi
cal
,
Keynesi
an,
monet
ari
sts,
demandsi
de,
andsuppl
y-si
dear
gument
s.

CLASSI
CALECONOMI
CSTHEORY
Cl
assi
caleconomi
cst
heor
yisbasedonf
ourpi
ll
ars/t
enet
s/pr
inci
ples

FIRSTPILLER:SAYSLAW
JeanBaptist
eSay,aclassi
cal
Frencheconomist
,st
udi
edt
henat
ureofmar
ket
s
i
nhi s1803book“Treat
iseonPoli
ti
calEconomy”

 Say’sLawofMar ketsstatesthatthesuppl yofagoodorser vi

cecreates
demandf orthatgoodorser vi
ce,i
.e.,supplycr eatesit
sowndemand.
 Ac cordingtoSay’sLaw, anyeconomi cagentmustf i
rstproducegoods
andser vicesthatbeforet heycanconsume, i
.e.,aperson’sabil
it
yto
demandgoodsandser vicesisadi rectresultofthepr oduct
ionactivi
ti
es
they’veundertaken.
 Sincepr oductioncomesf ir
standdemandf oll
owst heweal thcreat
ed
from production,Say’sLawi nfer
st hatitisimpor tanttolookatthesupply
sidei ft
hereisaf all
inconsumpt i
on

SECONDPI
LLAR:THECLASSI
CALTHEORYOFDEMANDFORMONEY
I
nthi
stheor
yofdemandFi
sher
sandot
hercl
assi
caleconomi
stl
ayst
resson
medi
um ofexchangef
unct
ionofmoneyi
.e.moneyasameanofbuyi
nggoods
andser
vices.
Al
ltr
ansact
ionsi
nvol
vingpur
chaseofgoodandser
vices,
rawmat
eri
alr
elat
est
o
moneyyasval
ueoft
ransact
ionsmade.
I
faccount
ingi
dent
if
yi.
e.val
uepai
dmustequalt
oval
uer
ecei
vedi
stooccur
.
Theval
ueofgoods,ser
vicesandasset
ssol
dmustbeequalt
otheval
ueof
moneypai
dfort
hem.Thusi
nanygi
venper
iodt
heval
ueofal
lgoodsser
vices
orasset
ssol
dmustequalt
henooft
ransact
ions(
T)mul
ti
pli
edbyt
heaver
age
pr
iceoft
hist
ransact
ionsmade(
P).Hencet
het
otalval
ueoft
ransact
ionsmade
i
sequalt
oPT. Si
mil
arl
ybecauset
heval
uepai
disi
dent
icalt
otheval
ueof
moneyf
low usedf
orbuyi
nggoodsser
vicesandasset
s.Theval
ueofmoney

11
f
low i
sequalt
othenomi
nalmoneysuppl
y(M)mul
ti
pli
edbyt
heaver
agenoof
t
het
imest
hequant
it
yofmoneyi
nci
rcul
ati
oni
sexchangedf
ort
ransact
ional
pur
posesi
.e.Tr
ansact
ionalvel
oci
tyofci
rcul
ati
on(
V),
MV=PT.

Wher
eM st
andsf
orQuant
it
yofmoneyi
nci
rcul
ati
on
V;Tr
ansact
ionsvel
oci
tyofci
rcul
ati
on
P;Aver
agepr
ice
T;Tot
alnumberoft
ransact
ions
Theabovei
dent
it
ywast
ransf
ormedi
ntoat
heor
yofdemandbymaki
ngsome
assumpt
ionsaboutt
hevar
iabl
esconcer
ned.
Accor
dingt
ofi
shert
heNomi
nalquant
it
yofmoneyi
sfi
xedbyCent
ralBankofa
count
ryandi
sassumest
obeagi
venquant
it
yinapar
ti
cul
arper
iodoft
ime.
Fur
thert
henumberoft
ransact
ionsi
naper
iodi
saf
unct
ionoft
heNat
ional
i
ncome(
Y)t
hegr
eat
ert
heYt
hegr
eat
ert
henumberoft
ransact
ions.Fi
sher
s
assumedf
ullempl
oymentofr
esour
cespr
evai
ledi
ntheeconomyandhencet
he
l
eveloff
ull
yempl
oyedr
esour
cesdet
ermi
nedt
hevol
umeoft
ransact
ions(
T).T
wast
her
efor
eassumedt
obef
ixedi
ntheshor
trunj
ustl
ikef
ullempl
oyment
l
evel
.
Themosti
mpor
tantassumpt
iont
hatmakest
hef
isher
sident
it
yat
heor
yof
demandi
sthatVr
emai
nsconst
antandi
sindependentofM,
PandT
Heur
guedt
hatVi
sdet
ermi
nedby:i
nst
it
uti
onalandt
echnol
ogi
calf
act
orst
hat
donotvar
yint
heshor
truni
.e.met
hodsandpr
act
icesoff
act
orpayment
ssuch
ast
hef
requencyofwagepaymentandt
hewor
ker
shabi
tsofpeopl
eregar
ding
spendi
ngoft
hei
rmoneyaf
tert
heyr
ecei
vet
hem anddevel
opmentofbanki
ng
andcr
edi
tsyst
em i
.e.t
hewaysandspeedwi
thwhi
chchequesar
ecl
ear
ed,
l
oanspai
dandr
epai
d.

I
ntheequi
li
bri
um anal
ysi
sthenomi
nalquant
it
yofMsmustbeequalt
othe
nomi
nalMoneydemandi
.e.Ms=Md

Wi
tht
heaboveassumpt
ionsf
isher
sequat
ionofexchangecanbewr
it
tenas

12
 (
Itshoul
dPTdi
videdbyvnotPV)

Accor
dingt
othef
isher
str
ansact
ionappr
oachdemandf
ormoneydependson
t
hef
lowi
ngt
hreef
act
ors.
 T;Tot
alnooft
ransact
ionsi
ntheeconomy
 P;Aver
agepr
icel
evel
 V;Tr
ansact
ionvel
oci
tyofci
rcul
ati
onofmoney.

13
THI
RDPI
LLAR:THEREALTHEORYOFI
NTEREST
 St
il
lanot
heri
mpor
tantpi
ll
arofcl
assi
calt
houghtwast
her
ealt
heor
yof
i
nter
est
.
 Tot
hecl
assi
caleconomi
st,t
hei
nter
act
ionofsavi
ngsbyhousehol
dsand
i
nvest
ment
sbybusi
nessdet
ermi
nedt
her
ateofi
nter
est
.
 Thi
stheor
yofi
nter
estwasa“
real
”theor
ybecauset
heunder
lyi
ngf
orcesi
n
t
heeconomyt
hatpr
oduced t
hesavi
ngsand i
nvest
mentpr
ocessatf
ull
empl
oymentwer
enotmonet
arybutwer
ether
ealpr
oduct
ivi
tyofcapi
taland
t
her
ealsacr
if
iceofconsumpt
ionofhousehol
ds.
 Ther
ealr
ateofi
nter
esti
sof
tendesi
gnat
edast
henat
uralr
ateofi
nter
est
becausei
tist
her
atet
hatpr
oducest
heequi
li
bri
um condi
ti
on i
n whi
ch
desi
redsavi
ngsf
rom f
ullempl
oymenti
ncomei
sexact
lyequalt
odesi
red
i
nvest
ment
.
 Thequest
ionswemustaskoursel
vesar
e;
i
) Whydoest
hehousehol
dsave?
i
i) Whydoest
hebusi
nessper
soni
nvesti
ncapi
talgoods?

i
) Savi
ngs
 I
ndi
vidualhousehol
dwasassumedt
ohaveat
imepr
efer
encet
hatpr
efer
sto
consumepr
esentgoodst
oconsumi
ngf
utur
egoods.I
fhousehol
dsaved,
t
heyhadt
ofor
got
hepr
esentconsumpt
ionofgoodsandser
vices.
 I
nor
dert
ogethousehol
dtomaket
hissacr
if
icei
thadt
obepai
dapr
emi
um
t
hatconsi
stedofmor
efut
uregoodsandser
vices.Thus,i
nor
dert
oinduce
t
hehousehol
dtosavei
thadt
orecei
vei
nter
estoni
tscashbal
ance.
 Thehi
ghert
hei
nter
estr
ate,t
hemor
ethesavi
ngsi
ntheeconomy;butsi
nce
t
heeconomywasassumedt
obeatf
ullempl
oyment
,themor
ethesavi
ngsi
n
t
heeconomy,
thel
essconsumpt
iont
her
ewasofgoodsandser
vices.
 Thi
seconomi
cbehav
iorofal
lthehousehol
dsi
smat
hemat
ical
lywr
it
tenas:

14
 Wher
e: i
ssavi
ngsi
ntheeconomy.
i
sthei
nter
estr
ate.
 A posi
ti
ver
elat
ionshi
p bet
ween t
heamountofsavi
ngsand t
hevar
ious
i
nter
estr
atesi
sshownassavi
ngsschedul
einf
igur
e3.
2

Fi
gur
e3.
2:ASavi
ngFunct
ion

 Thecl
assi
cal
sbel
ievedt
hatsavi
ngsbyhousehol
dwashi
ghl
yresponsi
vet
o
smal
lchangesi
nthei
nter
estr
ate.

i
i) I
nvest
ment
 Tur
ningt
othedemandsi
deoft
hecapi
talmar
ket
,ther
easonwhybusi
ness
i
nvest
edi
naddi
ti
onalcapi
tal
goodswast
omaxi
mizepr
ofi
ts.
 Butt
hei
mpor
tantvar
iabl
eaf
fect
ingabusi
nessi
nvest
mentdeci
sionwast
he
i
nter
estr
ate.
 Under
lyi
ng t
he i
nvest
mentdeci
sion was t
he cl
assi
calmi
croeconomi
c
conceptoft
hemar
ginalpr
oduct
ivi
tyofcapi
tal
.Gi
venashor
trunper
iodi
n
whi
chcapi
talgoodswer
etheonl
yvar
iabl
efact
orsofpr
oduct
ion,
ther
ewoul
d
bedi
mini
shi
ngmar
ginalpr
oduct
ivi
tyofcapi
tal
.
 Fort
he pr
ofi
tmaxi
mizi
ng condi
ti
on,a busi
nesswoul
d bor
row and add

15
 addi
ti
onaluni
tsofcapi
talgoodsupt
othepoi
ntwher
etheval
ueoft
he
mar
ginal pr
oduct of capi
tal equal
s t
he mar
ket r
ate of i
nter
est

 Theeconomi
cbehavi
orofal
lbusi
nesscanbewr
it
teni
nthef
orm ofan
equat
ionas:

Wher
e: i
saggr
egat
einvest
menti
ntheeconomy
i
sthei
nter
estr
ate.

 Thei
nver
ser
elat
ionshi
pbet
weent
heamountofi
nvest
mentandt
hevar
ious
i
nter
estr
atesi
sshownasani
nvest
mentschedul
eint
hef
igur
e3.
3.

Fi
gur
e3.
3:I
nvest
mentSchedul
e

 Thecl
assi
cal
sal
sobel
ievedt
hatt
hei
nvest
mentdeci
sionoft
hebusi
ness
washi
ghl
yresponsi
vet
osmal
lchangesi
nthei
nter
estr
ates.

EQUI
LLI
BRI
UM I
NTHECAPI
TALMARKET
 The i
nter
act
ion oft
he savi
ngs schedul
e and t
he i
nvest
mentschedul
e

16
 det
ermi
nest
heequi
l
ibr
ium r
ealr
ateofi
nter
est andt
heequi
li
bri
um l
evel

ofsavi
ngs andofi
nvest
ment i
nthecapi
talmar
ketasshowni
nfi
gur
e
3.
4

Fi
gur
e3.
4:I
nvest
mentSchedul
e

 I
nthecl
assi
calwor
ld,
asl
ongast
her
ewascompet
it
iononbot
hsi
desoft
he
capi
talmar
ket
,the mar
ketr
ate ofi
nter
estwoul
d equat
e savi
ngs and
i
nvest
ment
s.
 I
ntheevent ,ort
her
eisanexcesssuppl
yofcapi
talf
und,asi
ndi
cat
ed
byt
hedi
stanceAB,t
hei
nter
estr
atewoul
ddecl
i or
net e,agai
nbr
ingi
ng
savi
ngi
ntoequi
li
bri
um wi
thi
nvest
ment
.Theopposi
tewoul
doccuri
nthe
eventofexcessdemandofcapi
tal
fund,
asi
ndi
cat
edbydi
stanceCD.
 Toensur
ethatsavi
ngwasi
nequi
li
bri
um wi
thi
nvest
ment
,thei
nter
estr
ate
hadt
obef
lexi
blei
nthecapi
talmar
ket
.

17
Consequencesofi
nter
estr
ater
igi
dit
y
 Fi
xing ofi
nter
estr
ateabovet
heequi
li
bri
um i
nter
estr
atewoul
dlead t
o
excesssavi
ngs.
 Somei
nvest
ment
sincapi
talgoodswoul
dnott
akepl
acesi
nceal
ower
equi
li
bri
um i
nter
estr
at r
e,e,
isr
equi
redt
oequat
esavi
ngst
oinvest
ment
s.
 Thus,somecapi
talgoodswoul
dgounsol
dandempl
oymenti
nthecapi
tal
goods i
ndust
ry woul
d be caused by i
nter
estr
ate bei
ng f
ixed above
equi
li
bri
um i
nter
estr
ater
e.
Assi
gnment
Supposet
hatever
yonei
ntheeconomyatever
yint
erestr
atedeci
dedt
osave
mor
e,woul
dthi
sleadt
ounempl
oyment
?Inot
herwor
ds,woul
dthet
otalout
put
change?

Answer
 Ani
ncr
easei
nsavi
ngsatever
ylevelofi
nter
estl
eadst
othesavi
ngscur
vei
n
t
hecapi
talmar
kett
oshi
ftdownt
other
ightf
rom St
o asshow i
nthe
f
igur
ebel
ow,
produci
nganexcesssuppl
yofcapi
talf
unds.

18
 Gi
vent
hati
nter
estr
atei
sfl
exi
ble,excesssuppl
yofcapi
talf
undswoul
dput
pr
essur
eont
hef
inanci
ali
nst
it
uti
onst
olowert
hei
rint
erestr
ates.
 Equi
li
bri
um i
nter
estr
atewoul
ddecl
inef
rom t
o .

 Loweri
nter
estr
atei
nducesi
ncr
easesi
nfl
owofi
nvest
menti
ncapi
talgoods.
 Si
ncet
her
ehadbeenal
argerf
lowofsavi
ngsi
ntheeconomy,
ther
ewoul
dbe
decr
easei
ntheconsumpt
ionofconsumergoods.
 Not
e:t
hei
ncr
easei
nthei
nvest
menti
ncapi
talgoods(
shownas )woul
d
bej
ustmat
chedbyt
hedecl
inei
nspendi
ngonconsumergoods(
 The f
inalr
esul
tist
hatwhi
le out
puthas been r
edi
str
ibut
ed awayf
rom
consumergoods i
ndust
ri
es and t
owar
ds capi
talgoods i
ndust
ri
es,t
otal
out
puthasnotchangedandt
heeconomyi
sst
il
latf
ullempl
oyment
.

FOURTHPI
LLAR:WAGEANDPRI
CEFLEXI
BILI
TY
 Af
inalcor
ner
stoneofcl
assi
calmacr
oeconomi
csconcer
nst
hef
lexi
bil
it
yof
wagesandpr
icesi
nthel
abormar
ketandoneoft
hecl
assi
calpol
ici
esf
or
al
levi
ati
ngunempl
oyment
.
 Thecl
assi
calposi
ti
onont
hei
ssueofwageandpr
icef
lexi
bil
it
yist
ypi
fi
edi
n
t
het
heor
yofunempl
oyment(
1993)wr
it
tenbyt
heCambr
idgeeconomi
stA.
C.
Pi
gou.
 Wepr
esentbel
owt
heessenceofPi
gou’
svi
ewonwageandpr
icef
lexi
bil
it
y.
 We st
artwi
th a si
mpl
e aggr
egat
e pr
oduct
ion f
unct
ion.Recal
lthata
pr
oduct
ionf
unct
ionshowst
hemaxi
mum amountofr
ealout
putt
hatcanbe
pr
oducedf
rom aspeci
fi
edsetoff
act
ori
nput
,gi
vent
hecur
rentst
ateof
t
echnol
ogy.
 Anaggr
egat
epr
oduct
ionf
unct
ioncanbewr
it
tenas:

Wher
e i
stot
alout
put(
income)

19
 i
suni
tsofl
abor(
empl
oyment
)
i
saf
ixedst
ockofcapi
tal
.

 Not
e:si
ncecapi
talst
ocki
sfi
xed,
thet
imeper
iodi
stheshor
trun.
 Asuni
tsofl
aborar
eincr
eased,
thenat
i ncomeY,
onali wil
lal
soi
ncr
ease,
but
atadecr
easi
ngr
atebecauseoft
hel
awofdi
mini
shi
ngr
etur
ns.
 Fi
gur
e3-
7 showst
heaggr
egat
epr
oduct
ion f
unct
ion and i
sdr
awn wi
th
di
mini
shi
ngr
etur
nsst
art
ingf
rom t
heor
igi
n.O,

Fi
gur
e3.
7:

Der
ivi
ngt
hedemandf
orl
aborschedul
e
Apr
ofi
tmaxi
mizeri
naper
fect
lycompet
it
ivemar
ketwi
llempl
oyl
aborupt
othe
poi
ntwher
eval
ueofmar
ginalpr
oductofl
aborequal
sthepr
iceofl
abor
.

20
But

Wher
e i
smar
ginalpr
oductofl
abour
,whi
chi
sther
ati
oofachangei
n
out
put

(
Income)t
oachangei
nlabor .

i
spr
icel
eveloft
heeconomy
i
sthemoneywages.

 canbewr
it
tenas

 Thati
s,f
orpr
ofi
tmaxi
mizat
ion busi
ness hi
rel
aborup t
o poi
ntwher
e

mar
ginalpr
oductequal
srealwage

 But i
sthesl
opeoft
heaggr
egat
epr
oduct
ionf
unct
ionandi
sassumedt
o
bei
ncr
easi
ngatadecr
easi
ngr
atewi
thaddi
ti
onall
abour
.

Fi
gur
e3.
8:TheDemandf
orLabor

21
 Supposi
ngt
her
ealwage =2,
thent
henumberofl
abourt
obeempl
oyed

i
sfoundbyequat
ing t
orealwage

 Thi
simpl
iesempl
oyi
ng4uni
tsofl
aborf
orpr
ofi
tmaxi
mizat
ion.
 Theequat
ionf
ort
hedemandf
orl
aborcanbewr
it
tenas:

Wher
e i
sthedemandf
orl
abor

i
sther
ealwage

i
sfi
xedst
ockofcapi
tal
.

 Thel
abordemandequat
ioni
sshowni
nfi
gur
e3-
9,wi
tht
her
ealwage,

ont
hever
ti
calaxi
sanduni
tsofl
abor
,N,
ont
hehor
izont
alaxi
s.

Fi
gur
e3.
9

22
Gi
venar
ealwageof ,busi
nesswoul
dempl
oyf
orpr
ofi
tmaxi
mizat
ion

uni
tsofl
abor
.

Thesuppl
yofl
aborschedul
e
 Pi
goubel
ievedt
hatwor
ker
slookedatt
hei
rrealwagewhenof
fer
ingt
hei
r
ser
vicesf
orhi
reont
hemar
ket
.
 Theequat
ionf
ort
hesuppl
ycur
vef
orl
aborcanbewr
it
tenas:

Wher
e i
sthesuppl
yofl
abor

i
sther
ealwage.

Thesuppl
ycur
vef
orl
aborhadaposi
ti
vesl
opebecauseahi
gherr
ealwagehad
t
obeof
fer
edi
nor
dert
oat
tr
actaddi
ti
onalwor
ker
sint
othel
abormar
ket
.

23
Fi
gur
e3.
10:LaborSuppl
ySchedul
e

Equi
li
bri
um i
nthecl
assi
call
abormar
ket
Fi
gur
e3.
11

24
 I
nter
sect
ionofl
abordemandandl
aborsuppl
ydet
ermi
nest
heequi
li
bri
um

r
ealwageof andt
hel
eveloff
ullempl
oymentof i
nthecl
assi
cal

economy
.

 Supposet
her
ealwageof i
ntheeconomywasabovet
heequi
li
bri
um

r
ealwageof .

 Ther
ewoul
dbe uni
tsofunempl
oyedl
abor
.

 ,r
epr
esent
sthenumberofwor
ker
swho wer
eempl
oyed att
he

or
igi
nalequi
li
bri
um r
ealwageof buthavebeenl
aidof
fandnol
onger

haveaj
obatt
her
ealwage .

 i
sthenumberofwor
ker
swhohavebeendr
awni
ntot
hel
aborf
orce

becauseoft
hehi
gherr
ealwageof butcannotf
indaj
ob.

WhatwasPi
gou’
ssuggest
iont
oal
levi
ateunempl
oyment
?

25
 Ther
easonf
orunempl
oymentwast
hatr
ealwageof was“
toohi
gh”f
or

equi
li
bri
um oft
hesuppl
yanddemandcur
vesf
orl
abor
.
 I
fthewor
ker
swoul
dtakeacuti
nthei
rmoneywage,
W,t
hecostofpr
oduci
ng
goodsandser
vicescoul
dber
educedandt
hepr
icesofgoodsandser
vices
coul
dbel
ower
ed.
 Thusi
fwor
ker
swer
ewi
ll
ingt
otakeacuti
nthei
rmoneywage,
thepr
icel
evel

P,
woul
dfal
lint
hemoneywage,
W,andt
her
ealwage woul
dbel
ower
ed.

 Wor
ker
swoul
dcont
inuet
otakecut
sint
hei
rmoneywageandpr
icel
evel
woul
dcont
inuet
ofal
lunt
ilt
heequi
li
bri
um r
ealwagewasr
eachedandt
he
economywasr
est
oredt
oit
sful
l-
empl
oymentposi
ti
on.
 Accor
dingt
oPi
gou,i
fwagesandpr
iceswer
efl
exi
ble,af
ull
yempl
oyed
economywoul
dbeassur
ed.

THEBASI
CCLASSI
CALMODEL:AGRAPHI
CALANALYSI
S
 Ourpr
evi
ousdi
scussi
onoft
hepi
ll
arsofcl
assi
calmacr
oeconomi
cshas
pr
ovi
deduswi
thaf
oundat
ionf
rom whi
chwecannow begi
ntobui
lda
cl
assi
calmodel
.

Thebasi
ccl
assi
calequat
ions
Case1:t
hecl
assi
calmodel
’
sbasi
cequat
ionsf
ort
heaggr
egat
esuppl
y
1. pr
oduct
ionf
unct
ion

2.

3.

4.

Wher
e:

26
 i
snat
ionali
ncome
Ni
suni
tsofl
abor
i
sdemandf
orl
abor

i
ssuppl
yofl
abor

i
srealwage

i
sfi
xedst
ockofcapi
tal
.

Case2:cl
assi
calmodel
’
saggr
egat
edemandsi
deequat
ions
5. quant
it
ytheor
yofmoney

6.

Wher
e;
i
ssuppl
yofmoney
i
sincomevel
oci
ty
i
spr
icel
evel
i
sfi
nalout
putofgoodsandser
vices.
Theequat
ionf
ort
hecapi
tal
mar
ketar
e:
7.

8. capi
tal
mar
ket

9.

Wher
e: i
ssavi
ngs
Ii
sinvest
ment
ri
sreali
nter
estr
ate.

 Si
ncet
heear
lycl
assi
cal
economi
stsdi
dnoti
ntegr
atet
hei
rmar
ketst
ruct
ures,
i
twi
llbeassumedt
hatt
hei
nter
estr
atei
sfl
exi
bleandt
hatsavi
ngsand
i
nvest
ment
swi
ll
adj
ustt
othevar
iousdi
stur
bancesi
ntheeconomy.

27
 Thusi
npr
esent
ingagr
aphi
cpi
ctur
eoft
hecl
assi
calwor
ld,gr
aphf
ort
he
capi
talmar
ketneedbei
ncl
uded.

THEAGGREGATESUPPLYSI
DE
 Fort
heaggr
egat
esuppl
ysi
deoft
hebasi
ccl
assi
calmodelt
hepr
oduct
ion
andt
hel
abormar
ketar
erequi
red.

Fi
gur
e3.
13

28
 I
nor
dert
opr
oduce , uni
tsi
flaborar
erequi
red.
 Thel
abormar
keti
sdepi
ctedi
nfi
gur
e3-
12(
b)wi
thN ast
heuni
tsofl
abour

and ast
her
ealwage.

 Bot
hlabordemand andl
aborsuppl
y ar
efunct
ionsoft
her
eal

29
 wage .

 Thei
nter
sect
ionof and det
ermi
net
heequi
li
bri
um r
ealwageof

andt
hef
ullempl
oymentl
evelof .

 Al
inedr
awnf
rom t
hef
ullempl
oymentl
evelof i
nfi
gur
e3-
12(
b)t
othe
pr
oduct
ionf
unct
ioni
nfi
gur
e3-
12(
a)i
ndi
cat
est
hef
ullempl
oymentl
evelof
nat
ionali
ncomeof .

THEAGGREGATEDEMANDCURVE
 Thet
heor
yofaggr
egat
edemandi
ncl
assi
calt
heor
ywasi
mpl
iedbyt
henai
ve
ver
sionoft
hequant
it
ytheor
yofmoney.


 Asl
ongasmoneywasusedonl
yasamedi
um ofexchange,
incomevel
oci
ty
ofmoney wasassumedst
abl
e.

 ,r
epr
esent
stot
alspendi
ng on goods and ser
vices,oraggr
egat
e

demand and can be det

ermi
ned as soon as t
he money suppl
y,M,i
s
det
ermi
nedsi
nce i
saknownquant
it
y.

 Theabsol
utepr
icel
eveli
svar
iabl
ewhi
let
her
ealout
putofgoodsand
ser
vi O,
ces, i
saf
ixedquant
it
ysi
ncet
heeconomyi
satf
ullempl
oymentl
evel
.
 The cl
assi
cal t
heor
y of aggr
egat
e demand can be r
epr
esent
ed by
r
ect
angul
arhyper
bol
asi
ncet
hist
ypeofcur
veshowst
hevar
iousquant
it
ies
ofr
ealout
putt
hatcanbeboughtatvar
iouspr
icel
evel
sgi
vent
hesame
l
evel
soft
otalspendi
ng, ,
int
heeconomy.

 Fi
gur
e3-
13showst
hecl
assi
calaggr
egat
edemandcur
veasar
ect
angul
ar
hyper
bol
aconvext
otheor
igi
noft
hegr
aph,
wit
hnat
ionali Y,
ncome, i
dent
ical
t
orealout ,O,ont
put hever
ti
calaxi
sandt
hepr
icel ,P,ont
evel hehor
izont
al
axi
s.

30
Fi
gur
e3.
13:Aggr
egat
eDemand

 Si
ncet
heaggr
egat
edemandcur
vei
sdr
awnasar
ect
angul
arhyper
bol
a,any
poi
ntont
hatcur
veshowst
hevar
iouscombi
nat
ionsofr
ealout ,O,and
put
pr
icel
evel
,Pt
hatgi
vest
hesamel
evelofmoneyi
ncomewhi
chi
s
 I
nthef
igur
e,fO=50andP=2,
i thel
evelofmoneyi dbe100.An
ncomewoul
out
putof20andapr
iceof5woul
dgi
vet
hesamel
evelofmoneyi
ncome.

MONEYWAGEADJUSTMENT
 Fi
gur
e3-
14i
ll
ust
rat
est
hemoneywageadj
ust
mentgr
aph,wher
ethemoney
wageW,
isont
hever
ti
calaxi
sandt
hepr
icel
evel
,P,
isont
hehor
izont
alaxi
s.

31
 Thel
ineshowst
hevar
iouspossi
blecombi
nat
ionsofmoneywagesandpr
ice
l
evel
sthatgi
vet
hesamer
ealwageandcor
respondst
otheequi
li
bri
um r
eal

wagei
nthel
abormar
ket i
npanelBoff
igur
e3-
12.

Atpoi
nta,
ther
ealwage equal
s

Atpoi
ntb,
ther
ealwage =

Not
ethatt
hesl
opeoft
hel
ine

 I
fther
ealwagei
ncr
eases,t
hel
inebecomesst
eeper
,whi
chi
mpl
iest
hatt
he
l
inebecomesst
eeper
,whi
chi
mpl
iest
hatt
hel
iner
otat
esupwar
ds.
 Al
owerr
ealwagemeanst
hatt
hel
ineshoul
dber
otat
eddownt
owar
dst
heP
axi
s.

32
 I
ftheequi
li
bri
um r
ealwagel
inewas ,t
hent
hel
ineshoul
dbe

r
otat
eddownt
owar
dst
hehor
izont
alPaxi
s.

AGRAPHI
CALDI
SPLAYOFTHECOMPLETEBASI
CCLASSI
CALMODEL
 Fi
gur
e3-
16depi
ctst
hecompl
etecl
assi
cal
model
.

33
Fi
gur
e3.
16

PANELA PANELC

PANELB
PANELD

 The aggr
egat
e suppl
ysi
de i
srepr
esent
ed byt
he aggr
egat
e pr
oduct
ion
f
unct
ioni
npanel
(A)andf
ort
hel
abormar
keti
npanel(
B).
 Theaggr
egat
edemandsi
dei
sshownbyt
hegr
aphi
npanel(
C)oft
heOP
cur
vedr
awnasar
ect
angul
arhyper
bol
atheaggr
egat
edemandcur
ve.
 Fi
nal
ly,t
hegr
aphf
ort
hemoneywageadj
ust
menti
npanel(
D)i
slocat
ed
di
rect
lybel
owt
hegr
aphf
oraggr
egat
edemand.

34
 Howdowef
indt
hevar
iabl
esf
or ,NF, , and i
nthegr
aphi
cal

model
?
 St
artwi
tht
hei
nter
sect
ionof and ,whi
chgi
vest
hef
ull
-empl
oyment

equi
li
bri
um r
ealwageof andt
hel
evelof i
nthel
abormar
keti
n

panel(
B).
 Tr
aceupwar
dst
othepr
oduct
ionf
unct
ioni
npanel(
A)t
ofi
ndt
hel
eveloff
ull
empl
oymentr
eali
ncomeof whi
chcor
respondst
o i
nthel
abormar
ket
.
 Tr
ace f
rom t
he gr
aph f
ort
he pr
oduct
ion f
unct
ion i
n panel(
A)t
othe
aggr
egat
edemandcur
ve(
theOPcur
ve)i
npanel(
C)t
ofi
ndt
hepr
icel
evelof
whi
chmat
cheswi
th .Not
ethatr
eali
ncomeof i
sident
icalt
o

r
ealout
putofOF.
 Fi
nal
lyt
racef
rom i
ntheOP gr
aphi
npanel(
C)downt
othewage–

adj
ust
mentgr
aphi
npanel(
D)t
ofi
ndt
hemoneywageof f
ort
hepr
ice

l
evelof .

DI
STURBANCEI
NTHECLASSI
CALMODEL
 I
nempl
oyi
ngt
hecl
assi
calmodel
,onemustal
waysst
artwi
tht
heeconomyat
al
eveloff
ullempl
oyment
.
 Whenapar
ti
cul
ardi
stur
banceoccur
sint
heeconomy,suchasachangei
n
t
hesuppl
yordemandf
ormoneyort
hesuppl
yordemandf
orl
abor
,the
cl
assi
caleconomi
sti
sconcer
nedwi
thwhathappenst
o

i
) Ther
ealwager
ate
i
i) Thel
evelofempl
oyment
i
ii
) Reali
ncomeet
c

 I
not
herwor
ds,dot
hesemacr
ovar
iabl
esi
ncr
ease,decr
ease,orst
udyt
he

35
 same.

Case1:monet
arydi
stur
bancei
ncl
assi
calmodel

Fi
gur
e3.
17

36
 PANELA PANELC

PANELB
PANELD

(
a) Ani
ncr
easei
nthemoneysuppl
y.
Ani
ncr
easei
nmoneysuppl
ybyt
hecent
ralbanki
ncr
easest
heaggr
egat
e
demandshi
ft
ingt
heOPcur
vei
npanelCt
other
ightt
oOP.Why?
Realout
put i
sst
il
latf
ullempl
oymentbutsi
nceM hasi
ncr
eased

t
hel
evel
oft
otalspendi
ng, hasr
isen.
Si
nce Vi
( sconst
ant
),t
heOPcur
vehast
oshi
ftt
other
ightt
o

mai
ntai
nequal
it
ybet
ween andOP.

37
 Thust
hepr
icel
evelandt
hemoneywagei
ncr
easef
rom t
o and

t
o r
espect
ivel
y.
Howevert
her
ealvar
iabl
eint
heeconomyr
emai
nunchanged.

Ther
ealwagei
sst
il
l ,r
eali
ncomei
sst
il
l ,andt
hel
evel

ofempl
oymentr
emai
nsat .

(
b) Ani
ncr
easei
nincomevel
oci
ty(
V)
Ani
ncr
easei
nincomevel
oci
tywi
tht
hemoneysuppl
yfi
xedandr
eal
i
ncome atf
ullempl
oymentwoul
d pr
oduce t
he same r
esul
ts as an
i
ncr
easei
nmoneysuppl
y.
TheOP cur
vewoul
dshi
ftt
oOP,causi
ngpr
iceandmoneywagest
o
i
ncr
ease.

(
c) Adecr
easei
nthet
ransact
iondemandf
ormoney
Recal
lthatt
ransact
iondemandf
ormoneywaswr
it
tenas

Adecr
easei
nthet
ransact
iondemandf
ormoney woul
dbever
y

sameasani
ncr
easei
nincomevel
oci
tyof .
 TheOPcur
vewoul
dshi
ftr
i oOP’
ghtt ,andpr
iceandmoneywagewoul
dri
se.
 Toconcl
ude,al
ltheabovement
ionedmonet
arydi
stur
bancear
einf
lat
ionar
y,
andhavenoef
fectonr
ealvar
iabl
es.

Quest
ion:demonst
rat
eusi
ngt
hecl
assi
calmodelhowadecr
easei
nthemoney
suppl
y,adecr
easei
nincomevel
oci
tyandar
isei
nthet
ransact
ionsdemandf
or
moneywoul
daf
fectpr
ices,
moneywagesandr
ealvar
iabl
es.

38
Case2:r
ealdi
stur
bancei
nthecl
assi
calmodel
Ar
ealdi
stur
bancet
akespl
aceont
heaggr
egat
esuppl
ysi
deoft
hecl
assi
cal
modelandhasanef
fecton
i
) Realwage
i
i) Empl
oyment
i
ii
) Reali
ncome
i
v) Pr
iceandmoneywages

 Ourmai
nint
eresti
stoconsi
dert
heef
fectont
heeconomyoft
heshi
fti
n
l
abordemandorsuppl
ycur
veowi
ngt
ochangei
nvar
iabl
esot
hert
hant
he
r
ealwage.
Suchf
act
orsi
ncl
ude;
 Technol
ogi
cali
mpr
ovementi
naneconomy(
aff
ect
slabordemand)
 Popul
ati
ongr
owt
h(af
fect
slaborsuppl
y)

Ashi
fti
nthedemandf
orl
abor
 Technol
ogi
cal i
mpr
ovement i
n an economy whi
ch enhances l
abor
pr
oduct
ivi
tyi
soneoft
hef
act
orswhi
chcoul
dpr
oduceanupwar
dshi
fti
nthe
aggr
egat
epr
oduct
ionf
unct
ion.
 Si
ncet
hedemand f
orl
abori
sthesl
opeoft
hepr
oduct
ion f
unct
ion,as
pr
evi
ousl
ydemonst
rat
ed,t
hel
abori
sthesl
opeoft
hepr
oduct
ionf
unct
ions,
aspr
evi
ousl
ydemonst
rat
ed,t
hel
abordemandcur
vewoul
dshi
ftt
other
ight
wi
thanupwar
dshi
fti
nthepr
oduct
ionf
unct
ion.
 Theshi
ftoft
hepr
oduct
ionf
unct
ionandoft
hel
abordemand i
s
showni
nPanelAandBoff
igur
e3.
18

39
Fi
gur
e3.
18

PANELA PANELC

PANELB
PANELD

 Newf
ullempl
oymentequi
li
bri
um i
ntheeconomyi
s wi
th

i
) Ahi
gherr
ealwageof

40
 i
i) Ahi
gherl
eveloff
ullempl
oymentof

i
ii
) Ahi
gherr
eali
ncomeof

i
v) Al
owerpr
icel
evelof

 Bef
oredet
ermi
ningt
hemoneywagei
npanelD,
onemustr
otat
ethef
unct
ion
i
nthepanelD.

 Si
ncet
heequi
li
bri
um r
ealwagehasr
isent
o anupwar
dsr
otat
ionoft
he

f
unct
ioni
npanel
Discal
ledf
or
 Dependi
ngont
heamountofr
otat
ion,onecoul
dfi
ndt
hatt
hemoneywage
hadr
isen,
stayedt
hesame,
orf
all
en(
indet
ermi
nat
e)
 However
,iti
sdi
ff
icul
ttodet
ermi
net
heamountofr
otat
ion,maki
ngmoney
wage i
ndet
ermi
nat
e gr
aphi
cal
ly when t
her
eis an upwar
ds shi
fti
nthe
demandf
orl
abor
.

Ashi
fti
nthesuppl
yforl
abor
 Popul
ati
on gr
owt
his one f
act
orwhi
ch woul
dlead t
oar
ight
war
d and
downwar
dshi
fti
nthesuppl
yofl
aborf
rom t
o .

 Fi
gur
e3-
19showst
hei
mpactofani
ncr
easei
nlaborsuppl
y.

41
Fi
gur
e3.
19

PANELA PANELC

PANELB
PANELD

 Thenewequi
li
bri
um i
ntheeconomyi
s wi
th

42
 i
.Al
owerr
ealwageof

i
i.Ahi
gherl
eveloff
ullempl
oymentof

i
ii
.Ahi
gherr
eali
ncomeof

i
v.Al
owerl
evelpr
icel
evelof

 Todet
ermi
net
hemoneywage,t
hel
ineoutoft
heor
igi
nwaspanel(
D)must

f
ir
stber
otat
eddownwar
dssi
ncet
her
ealwageof i
slowert
han .

Thent
hemoneywagecanbef
oundf
orapr
icel
evelof ,i
tis ,whi
chi
s

l
owert
han .

ANANALYSI
SOFUNEMPLOYMENTWI
THFI
XEDMONEYWAGES.
ANOTHERCLASSI
CALPOLI
CYPROPOSAL
 Weanal
yzet
hepr
obl
em ofunempl
oymentwhenmoneywagesar
efi
xed
usi
ngt
hecl
assi
calmodel
.
 Accor
dingt
oA.
C.Pi
gou,t
heunempl
oymentpr
obl
em coul
dbesol
vedby
wor
ker
staki
ngcut
sint
hei
rmoneywages.
 Butsupposewor
ker
swoul
dnott
aker
educt
ioni
nthei
rmoneywages,what
ot
herpol
i
cywoul
dbeappl
iedt
osol
vet
heunempl
oymentpr
obl
em?
 I
nfi
gur
e3-
20wedemonst
rat
etheunempl
oymentpr
obl
em associ
atedwi
th
f
ixedmoneywageandt
hecl
assi
cal
pol
icypr
oposal
.

43
Fi
gur
e3.
20

44
 PANELA PANELC

PANELB
PANELD

 Thevar
iabl
escor
respondi
ngt
othef
ullempl
oymentequi
li
bri
um ar
e

and .

 Supposet
hemoneywagei
sfi
xedat andapr
icel
evelof i
sfoundi
n
panel(
D).

45
 Thi
spr
ovi
desar
ealwageof whi
chi
sabovet
heequi
li
bri
um r
ealwage

of i
nthel
abormar
ket
.

 Thus t
he r
ealwage i
stoo hi
gh f
orf
ullempl
oymentequi
li
bri
um i
nthe

economy
.Whent
her
ealwagei
s unempl
oymenti
sint
heamountof

i
npanel
(B)
.

 Thel
evelofempl
oymenti
s andr
eali
ncomei
s ,f
all
ingbel
ow t
hef
ull

empl
oymentr
eali
ncome .

 Si
ncet
heout
putl
evelf
all
sto (
since )
,fort
hel
evelofspendi
ngt
o

r
emai
nthesame ,associ
atedt
othef
alli
nout
putwoul
dbea

pr
ice ,
whi
chi
shi
ghert
han i
npanel(
C).

 Si
nce i
sgr
eat
ert
han ,t
hemoneywageadj
ust
mentl
inei
npanel

(
D)mustber
otat
edupt
owar
dst
hever
ti
calW axi
s.

Possi
bler
emedi
est
otheunempl
oymentpr
obl
em
 Si
ncet
hemoneywagei
sfi
xedat t
heonl
ypossi
blewayofl
ower
ingt
he
r
ealwagei
stoi
ncr
easet
hepr
icel
evel
.
 Thi
swoul
dcauset
her
ealwaget
ofal
landbeequalt
othef
ullempl
oyment

equi
li
bri
um r
ealwage

 Tot
hecl
assi
caleconomi
sts,ani
ncr
easei
nthemoneysuppl
ybyt
hecent
ral
bankwoul
dincr
easet
hepr
icel
evelandt
her
ebyl
owert
her
ealwage.Asa
r
esul
templ
oymentandr
eali
ncomewoul
dbeexpandedt
owar
dst
hef
ull
empl
oymentl
evel
.
 Asdemonst
rat
edi
npanel(
C)ani
ncr
easei
nmoneysuppl
yshi
ft
stheOP
cur
ve suf
fi
cient
lyt
othe r
ightt
o ,pr
oduci
ngapr
icel
evelof

46
 ,
whi
chwoul
dcauset
her
ealwaget
ofal
lto wage.

Ther
oleoff
iscalpol
icyi
ncl
assi
caleconomi
cs
 Thecl
assi
caleconomi
stssaw nor
olef
orf
iscalpol
icy.Thecl
assi
calbel
ief
wast
hatgover
nmentspendi
ngi
nexcessofcur
rentt
axr
evenue“
crowded
out
”pr
ivat
einvest
mentexpendi
tur
es.

Thecl
assi
calcr
owdi
ng–outef
fect
 Suppose t
her
eis unempl
oymenti
nthe economy and t
he gover
nment
at
tempt
stoi
ncr
easet
hel
evelofnat
ionali
ncomebyi
ncr
easi
nggover
nment
spendi
ngonpubl
icgoods(
suchasr
oads,
dams)oronpubl
icser
vices(
such
aseducat
ion)t
hati
trecei
vesi
ntaxcol
lect
ion.
 The gover
nmentwhen f
aced wi
th a budgetdef
ici
thas t
wo choi
ces i
n
f
inanci
ngi
t.
i
) Pr
intmoneyt
hrought
hecent
ralbank
i
i) Bor
rowbysel
li
ngbondst
othegener
alpubl
ic.

 I
fthegover
nmentpr
int
edmoneyandusedi
ttopur
chasegoodsandser
vices,
t
heni
twoul
dbei
ncr
easi
ngt
hemoneysuppl
y,andt
hiswoul
dbeconsi
der
ed
monet
arypol
icyandnotf
iscal
pol
icy.
 Anal
ter
nat
ivet
opr
int
ingmoneyi
stheopenmar
ketoper
ati
onsbyt
hecent
ral
bank.Thecent
ralbankwoul
dbuybondsf
rom t
hepubl
ici
nor
dert
oexpand
t
hemoneysuppl
y.
 Butcr
owdi
ngoutr
esul
tsf
rom t
hesel
li
ngofnew gover
nmentbondsbyt
he
t
reasur
ytof
inancet
hegover
nmentdef
ici
t.
 Thet
reasur
yinor
dert
ocoaxt
hepubl
ici
ntobuyi
nggover
nmentbondsr
ather
t
hanbondsi
ssuedbypr
ivat
ebusi
nessl
ower
sthepr
iceofgover
nmentbonds,
whi
chwoul
dconcur
rent
lyi
ncr
easet
hei
nter
estr
ateont
hosebonds.
 Thei
mpactoft
hishi
gheri
nter
estr
ateonpr
ivat
esavi
ngandonnetpr
ivat
e

47
 i
nvest
menti
nthecl
assi
cal
economyi
sil
lust
rat
edi
nfi
gur
e3-
21.

Fi
gur
e3.
21

 Wi
thnot
reasur
yint
erf
erencei
nthepr
ivat
ecapi
talmar
ket
,pr
ivat
esavi
ngand
pr
ivat
einvest
mentwoul
dbei
nequi
li
bri
um atani
nter
estr
ateof .

 Equi
li
bri
um l
evelofsavi
ng and i
nvest
mentwoul
d be at and

r
espect
ivel
y.
 Butwhent
het
reasur
ysol
dgover
nmentbonds,
thei
nter
estr
atewoul
dri
set
o
.

 Sav
ingwoul
dri
set
oal
evelof andi
nvest
mentwoul
dfal
ltoal
evelof .
 Tot
hecl
assi
caleconomi
stsani
ncr
easei
ngover
nmentspendi
ngf
inanced
bygover
nmentbondsr
athert
hanbyt
axr
ecei
ptswoul
dcauseaf
alli
npr
ivat
e
i
nvest
mentspendi
ngoncapi
tal
goods.
 Bycr
eat
ingi
nter
estr
atesabovet
heequi
li
bri
um r
ate,t
hegover
nmentwoul
d
cr
owdoutpr
ivat
einvest
mentr
esul
ti
ngi
nnoef
fectonnat
ionali
ncome.

48
Theef
fectoft
axi
ncr
ement
 I
finst
eadt
hedef
ici
tint
hebudgetwasf
inancedbutt
axr
evenuer
athert
han
gover
nmentbonds,
pri
vat
espendi
ngwoul
dbeadver
sel
yaf
fect
ed.
 I
f per
sonali
ncome t
axes war
eincr
eased t
hen pr
ivat
e consumpt
ion
expendi
tur
ewoul
ddecl
ine.I
ftaxesoncor
por
atepr
ofi
tswer
erai
sedt
hennet
i
nvest
mentspendi
ngwoul
dfal
l.
 Thusgover
nmentspendi
ng woul
dincr
easeand pr
ivat
espendi
ng woul
d
decr
ease,
wit
hnoef
fectonnat
ionali
ncomeandempl
oyment
.
 Accor
dingt
othecl
assi
caleconomi
stst
henetef
fectoff
iscalpol
icywas
t
hati
thadnoef
fectont
hel
evelofnat
ionali
ncome.
 As a r
esul
tthe cl
assi
caleconomi
stsf
eltt
hatt
he gover
nmentshoul
d
bal
ancet
hebudget
,andwasnotnecessar
yasanact
ivepol
icypar
ti
cipant
.
Theeconomyadj
ust
edi
tsel
f.
 The cl
assi
caleconomi
sts bel
ieved t
hateconomi
c pr
obl
ems such as
unempl
oymentori
nfl
ati
on wer
etempor
ary phenomena,and t
hatsel
f-
cor
rect
ing f
orces woul
d al
ways count
eractt
his shor
t-
run ort
empor
ary
occur
rence.Shoul
dtheeconomyf
ailt
oadj
ustqui
ckl
yenought
osui
tsoci
ety,
monet
arypol
icywoul
dbei
mpl
ement
ingt
ospeedt
her
etur
ntoeconomi
c
heal
th.
 Howevert
heexi
stenceofaut
omat
icmechani
sm i
neconomi
csyst
emswas
putt
odoubtf
oll
owi
ngt
hegr
eatdepr
essi
onoft
he1930st
hatt
ookhol
dof
t
heUni
tedSt
atesandmostot
hernat
ions.I
ndust
ri
alpr
oduct
ion,whol
esal
e
andr
etai
lpr
icesandr
ealt
otalandpercapi
tai
ncomef
elldr
ast
ical
lybel
ow
t
hei
r1929l
evel
sforal
mostadecade.Unempl
oymentr
eachedal
lti
mehi
gh.
JohnKeynesadvocat
edgover
nmenti
nter
vent
ionembodi
edi
nfi
scalpol
icyt
o
suppl
ementmar
ketmechani
sm.
 I
n 1936,Keynes publ
ished hi
stheor
eti
calat
tack on t
he f
oundat
ion of
cl
assi
calmacr
otheor
y,TheGener
alTheor
yofEmpl
oymentI
nter
estand
Money.Keynescr
it
ici
sm t
othecl
assi
cal
pil
lar
sispr
esent
edbel
ow.

KEYNESCRI
TISM OFSAY’
SLAW

49
 Ont
hebasi
sofSay’
slaw t
hepr
oduct
ionofgoodsandser
vicescr
eat
ed
i
ncome f
ort
he househol
dthatwas consumed orsaved orbot
h,as
det
ermi
nedbyt
her
ateofi
nter
est
.Mor
esavi
ngsandl
essconsumpt
ionof
goodsbyhousehol
dresul
tedf
rom ar
isi
ngi
nter
estr
ate.
 I
naddi
ti
ont
her
ateofi
nter
est
swast
hevar
iabl
ethatbr
oughtsavi
ngsi
nto
equi
li
bri
um wi
tht
hei
nvest
ment
.
 I
n a per
fect
lycompet
it
ive mar
ket
,the onl
yequi
li
bri
um posi
ti
on f
ort
he
economywast
hatoff
ull
-empl
oymentl
evelofpr
oduct
ion.
Keynes’
scr
it
ici
sm
 Keynesgener
all
yaccept
edt
heCl
assi
cal
s’not
ionr
egar
dingi
nvest
mentas
bei
ngaf
fect
edbyt
hei
nter
estr
ate,buthedi
dn’
tacceptt
hei
rconcept
ionof
t
henat
ureofhousehol
dsavi
ngs.
 Accor
dingt
oKeynesbot
hsavi
ngsandconsumpt
ioni
ntheeconomywas
det
ermi
ned pr
imar
il
y by t
he l
evelofi
ncome and notas t
he cl
assi
cal
economi
stbel
ieved,
byt
hei
nter
estr
ate.
 Thebasi
sfort
hishy
pot
hesi
saboutt
hehousehol
d’ssavi
ngsbehavi
orr
est
ed
on whatKeynescal
led a “
fundament
alpsychol
ogi
call
aw”whi
ch when
si
mpl
y par
aphr
ased means t
hatas i
ncome i
nthe economy i
ncr
eases,
househol
donaver
agei
ncr
easest
hei
rconsumpt
ionofgoodsandser
vices.
 Butt
hisi
ncr
easei
slesst
hanpr
opor
ti
onat
eincr
easei
nhousehol
dincome.I
n
ot
herwor
dssavi
ngsal
soi
ncur
sandi
tincr
easesasi
ncomer
ises.
 Thus accor
ding t
o Keynes’anal
ysi
s oft
he economy,t
he cr
uci
alf
act
or
det
ermi
ning savi
ngs and consumpt
ion behavi
ori
sincome and nott
he
i
nter
estr
ate.
 Keynest
houghtt
hati
fincomepl
ayedpr
imar
yrol
einaf
fect
ingsavi
ng,t
hen
t
her
e was t
he possi
bil
it
ythatt
he economy coul
dreach a posi
ti
on of
equi
li
bri
um atl
esst
hanf
ullempl
oyment
.
 Thecauseofanunempl
oymentequi
li
bri
um posi
ti
onwasadef
ici
encyi
n
aggr
egat
edemand,ori
nthel
evelofspendi
ngbyhousehol
donf
inalgoods
andser
vices(
C)andi
nvest
mentspendi
ngbybusi
nessoncapi
talgoods(
I)i
n
t
heeconomy,
togener
atef
ullempl
oymentl
evelofpr
oduct
ion.

50
 Forexampl
e:i
ftheamountofsavi
ngswer
egr
eat
ert
hant
heamountof
i
nvest
mentspendi
ngatf
ullempl
oymentl
evelofi
ncome,somegoodsand
ser
vices woul
d go unsol
d. I
ndi
cat
ing t
hat t
her
e woul
d be enough
consumpt
ionspendi
ngt
omai
ntai
naf
ullempl
oymentl
evelofi
ncome.
 Busi
ness,f
indi
ngi
nvent
ori
esofunsol
dgoodsont
hei
rhand,woul
dhavet
o
l
ayof
fwor
ker
scr
eat
ingunempl
oymenti
nthel
aborf
orce.Thi
swoul
dcause
t
hel
evelofi
ncomei
ntheeconomyt
ofal
lunt
ilsavi
ngsi
sagai
nbr
oughti
nto
equi
li
bri
um wi
thi
nvest
ment
s.
 Thus Keynes ar
gued t
hati
twas nott
he i
nter
estr
ate butt
he l
evelof
aggr
egat
eincomet
hatadj
ust
edt
obr
ingt
hel
evelofsavi
ngsi
ntoequi
li
bri
um
wi
tht
hel
evelofi
nvest
mentandf
urt
hert
hatwhi
leaneconomymayat
tai
n
equi
li
bri
um i
tdoesnotnecessar
il
yat
tai
nitatf
ullempl
oyment
.
 Anot
herat
tackbyKeynesonSay’
sLawcent
eredont
heconceptofhoar
ding
byhousehol
dint
he economy.The hol
ding ofi
dle moneybal
ancesby
househol
dwoul
dbedest
abi
li
zingt
otheeconomysi
ncesomeconsumeror
capi
talgoodswoul
dgounsol
dhencei
nval
idat
ingSay’
sLaw.
 Butt
he cl
assi
caleconomi
sts consi
der
ed hoar
ding an i
rr
ati
onalt
ype of
economi
c behavi
orbecause t
he househol
dthathoar
ded was f
orgoi
ng
i
nter
estt
hati
tcoul
dear
noni
tsi
dlemoneybal
ances.

Keynes’
scr
it
ici
sms
 Keyneshoweverwasabl
etoshow whyhoar
dingbyhousehol
dmi
ghtbea
r
ati
onalact
ion.Accor
dingt
ohi
m,househol
dwoul
dhol
didl
emoneybal
ances
f
orspecul
ati
vemot
ive.
 Keynesdemonst
rat
edt
hathousehol
dscoul
dvi
ew moneybot
hasanasset
al
ter
nat
ivet
oot
heri
nter
est
-bear
ingasset
sandasamedi
um ofexchange
andt
hathousehol
dscoul
dcr
eat
eunempl
oymentbyhol
dingi
dlemoney
hence,
inval
idat
ingSay
’sLaw.
 Keynesal
soar
guedt
hatatl
owi
nter
estr
atest
her
ecoul
dbea l
iqui
dit
ytr
ap
monet
arypol
icyaspr
oposedbyt
hecl
assi
caleconomi
stwoul
dnotr
est
ore
t
heeconomyt
oful
lempl
oyment
.

51
TheKeynesi
anmot
iveofhol
dingmoneybal
ances.
 Keynesdi
videdt
hedemandf
ormoneyi
ntot
hreesepar
atemot
ives.
i
) t
het
ransact
ionmot
ive
i
i) t
hepr
ecaut
ionar
ymot
ive
i
ii
) t
hespecul
ati
vemot
ive

Thet
ransact
ionsmot
ive
 Thet
ransact
ionsdemandf
ormoneyshowshow muchmoneyhousehol
d
wantt
ohol
dinor
dert
ocar
ryoutt
hei
rday-
to-
dayt
ransact
ions.
 Keynesbor
rowedt
het
ransact
ionsmot
ivef
orhol
dingcashbal
ancesf
rom
Cambr
idgequant
it
ati
vet
heor
ist
.

Wher
e i
sthet
ransact
iondemandf
ormoney

i
sthesameast
heCambr
idgek,andi
sapr
opor
ti
onof
moneyi
ncomeof hel
dfort
ransact
ionpur
pose.
 Expr
essi
ngt
het
ransact
iondemandf
ormoneyi
nrealt
erms

Wher
e i
sther
eal
moneybal
ancesdemandedf
ort
ransact
ion.

i
sthel
evelofr
eali
ncomewhi
chi
sident
icalt
othephysi
cal
out
putofgoodsandser
vicesO
 Si
ncet
hespendi
nghabi
toft
hecommuni
tychangedver
yli
tt
lei
ntheshor
t
r
un,
thet
ransact
iondemandf
ormoneywast
houghtt
obeaconst
antf
ract
ion

52
 oft
hel
evelofi
ncomei
ncr
easedi
ntheeconomy,
househol
dsdesi
redt
ohol
d
mor
emoneybal
ancei
nor
dert
ocar
ryoutt
hei
rdayt
odayt
ransact
ion.

45

 Thesl
opeoft
hel
ine=k,
whi
chi
slesst
han1.Si
nceonl
ysomepr
opor
ti
onof
r
eali
ncomei
shel
dfort
ransact
ionspur
pose.

Thepr
ecaut
ionar
ymot
ive
 Keynespoi
ntedoutt
hathousehol
dhadapr
ecaut
ionar
ymot
ivef
orhol
ding
moneybal
ancessi
nceunf
oreseencont
ingenci
escoul
dar
ise.
 Unf
oreseencont
ingenci
esmeantsuchemer
genci
esasal
ongi
ll
ness,
lossof
one’
sjob,
oranaut
omobi
leacci
dent
.
 Ast
hei
ncomeoft
hehousehol
dincr
ease,mor
emoneyi
sdemandedbyi
tto
meetpr
ecaut
ionar
yneeds.
 Thus,t
he pr
ecaut
ionar
y demand f
or money can be i
ncl
uded i
nthe
t
ransact
iondemandf
ormoneyequat
ion,
 Bot
hthet
ransact
ionsdemandf
ormoneyandt
hepr
ecaut
ionar
ydemandf
or
moneyar
eposi
ti
vel
yrel
atedt
oai
dar
efunct
ionoft
hel
evelofi
ncome.

Thespecul
ati
vedemandf
ormoney
 WasKeynes’mosti
nnovat
iveconcept
.Itwasmai
nlybasedont
hei
deat
hat

53
 t
hehousehol
dfacedawor
ldofuncer
tai
ntyaboutt
hef
utur
emar
ketval
ueof
i
tsear
ningasset
s.
 Thehousehol
dhadaper
cept
ionaboutwhet
hert
hepr
iceofanassetwoul
d
r
iseorf
alli
nval
uei
nthef
utur
eand,
ther
efor
e,aboutwhet
herornoti
twoul
d
exper
ienceacapi
tal
gai
norl
esswheni
tsol
dtheasset
s.
 I
n Keynes’
s di
scussi
on of t
he specul
ati
ve demand f
or money,t
he
househol
d’schoi
cewaspr
imar
il
ybet
weent
wot
ypesofasset
s-bondsor
money.Byemphasi
zingt
hespecul
ati
vedemandf
ormoney,Keyneswas
depar
ti
ng f
rom t
he si
mpl
ercl
assi
calconceptand poi
nti
ng outt
hatt
he
househol
dcoul
dvi
ewmoneyasanasset
.Moneywast
her
efor
eper
for
minga
st
ore-
of-
val
uef
unct
ion.

Der
ivat
ionoft
hespecul
ati
vedemandcur
ve
 I
nthegener
alt
heor
y,Keynesr
efer
redt
othespecul
ati
vemot
iveaspar
tofa
househol
d’sl
iqui
dit
ypr
efer
red,si
ncemoneyi
sthemostl
iqui
dasset
sthat
t
hehousehol
dcanhol
d.
 Dependi
ngont
hehousehol
d’spr
efer
encebet
weenei
therhol
dingbondsor
hol
ding money,onecan const
ructwhathasbeen t
ermed aspecul
ati
ve
demandf
ormoneycur
vef
ort
heeconomy.
 Wef
ir
stneedt
oexpl
oret
her
elat
ionshi
pbet
weent
hepr
icesofamar
ket
abl
e
bond and t
he i
nter
estr
ate on t
hatbond because t
hatr
elat
ionshi
pis
f
undament
alt
othedevel
opmentofaspecul
ati
vedemandf
ormoneycur
ve.
 Forasi
mpl
eexampl
ewechooseat
ypeofbondcal
ledaconsol
,whi
chhas
nomat
uri
tydat
eorr
edempt
ionval
ue,butwhi
chpayscer
tai
nnumberof
dol
lar
s(R)peryear
.Theonl
ywayofconver
ti
ngt
heconsoli
ntomoneyi
sfor
onespecul
atort
osel
ltoanot
herspecul
atori
nthebondmar
ket
.
 Thepr
iceoft
hebondi
sgi
venas

Wher
e i
sthepr
iceoft
hebond.
i
sthei
nter
esti
ncomei
ndol
lar
speryear

54
 i
sthei
nter
estr
ateont
hebond.
 Ther
eexi
stsani
nver
ser
elat
ionshi
pbet
weent
hepr
iceoft
hebondandt
he
i
nter
estr
ateonbond.Thehi
ghert
hepr
iceoft
hebond,
thel
owert
hei
nter
est
r
ate,
andvi
cever
sa.
 Not
ethatt
heconst
ruct
ionoft
hespecul
ati
vedemandf
ormoneycur
vei
s
based on f
luct
uat
ionsi
nthepr
iceofbondsand t
heassoci
ated mar
ket
i
nter
estr
ates.
 Thechoi
cebet
weenhol
dingi
dlemoneybal
anceandhol
dingbondsdepends
ont
hehousehol
dex
pect
ati
onaboutt
hef
utur
emovementoft
hemar
ketr
ate
ofi
nter
est
.
 Eachhousehol
dwoul
dhavef
ormedanat
ionaboutwhati
tconsi
der
sthe
nor
malr
ateofi
nter
est(
ornor
malbondpr
ice)basedonpastexper
iences
wi
tht
hebondmar
ket
.
 I
ftheact
ualr
ateofi
nter
estcur
rent
lyvar
iesf
rom t
henor
malr
ateofi
nter
est
,
t
hehousehol
dwoul
dhol
dthebel
ieft
hatt
heact
ualr
ateofi
nter
estwi
llr
etur
n
t
othenor
mal
rat
eofi
nter
esti
nthef
utur
e.
 I
ftheact
ualr
ateofi
nter
est(
say
,10%)wer
eabovet
henor
malr
ateofi
nter
est
(
say,
8%)t
hehousehol
dwoul
dexpectt
heact
ualr
ateofi
nter
estt
ofal
l(t
o8%)
andwoul
dther
efor
eexpectt
hepr
iceofbondst
ori
se.
 I
nthi
scaset
hehousehol
dwai
ti
ngt
omakeacapi
talgai
nwoul
dinvesti
n
bondsandwoul
dnothol
didl
especul
ati
vemoneybal
ance.
 However
,ift
heact
ualr
ate(
say
,6%)wer
ebel
owt
henor
malr
ate(
say,
8%)t
he
househol
dwoul
dexpectt
heact
ual
rat
e(say
,6%)t
ori
set
othenor
malr
ate.
 I
nthi
scase,bond pr
iceswoul
dfal
land t
he househol
d notwi
shi
ng t
o
exper
ienceacapi
tall
ossoni
tsasset
swoul
dli
qui
dat
eit
sbondsandwoul
d
hol
dasanassetwoul
dli
qui
dat
eit
sbondsandwoul
dhol
dasanasseti
nit
s
por
tfol
ioonl
yidl
especul
ati
vemoneybal
ance.
 Consi
dert
woext
remecases.

Case1:act
uali
nter
esti
shi
ghert
hanal
lthegr
oupnor
malr
atesofi
nter
est
.
Al
lgr
oupswoul
dcer
tai
nlyexpectt
hepr
iceofbondt
ori
sesi
ncet
hepr
iceof

55
bondi
scur
rent
lyati
tsl
owestpossi
blel
evel
.
Al
lspecul
ator
swi
ll
pref
erhol
dingbondsandnotspecul
ati
vemoneybal
ances.

Case2:act
ualr
ateofi
nter
esti
sati
tsl
owestandbel
owal
lgr
oupsnor
malr
ateof
i
nter
est
.
Thepr
iceoft
hebondi
sati
tshi
ghestandal
lhousehol
dst
hatspecul
atei
nthe
bondsmar
ketexpect
sthebondspr
icet
odecl
inei
nfut
ureasact
uali
nter
estr
ate
r
isest
owar
dst
henor
malr
ateofi
nter
est
.
Al
lhousehol
dwi
ll
,ther
efor
e,hol
didl
emoneybal
ance.I
nef
fectt
her
eisabsol
ute
l
iqui
dit
y.
Theabsol
utel
iqui
dit
yposi
ti
onhasbeent
ermedaKeynesi
anl
iqui
dit
ytr
ap
The i
nver
se r
elat
ionshi
p bet
ween act
ualmar
ketr
ate ofi
nter
estand t
he
specul
ati
vemoneydemandi
spr
esent
edi
nthef
igur
e4.
2bel
ow.

Fi
gur
e4.
2:TheSpecul
ati
veDemandf
orMoney

Act
ual
market

Specul
ati
vedemand
formoney

 Thel
iqui
dat
edt
rapi
sil
lust
rat
edbyt
hehor
izont
alpor
ti
onoft
hespecul
ati
ve
demand f
or money cur
ve.Not
ethat t
he l
iqui
dit
ytr
ap woul
d be a
phenomenon od a depr
essi
on and associ
ated wi
th hi
gh l
evel of
unempl
oyment
.

56
 Keynes’
tot
aldemandf
ormoneycanbeexpr
essedas

Wher
e i
sthet
ransact
ionandpr
ecaut
ionar
ydemandf
ormoney.

i
sthespecul
ati
vedemandf
ormoney

 Thus,t
het
otaldemandf
ormoneydependsont
hel
evelofi
ncomeandt
he
mar
ketr
ateofi
nter
est
.

KEYNES’
SCRI
TISM OFTHEREALTHEORYOFI
NTEREST
 I
nthecl
assi
calanal
ysi
s,t
her
ealt
heor
yofi
nter
estwasbasedonsavi
ngsand
i
nvest
ment
s.
 Bot
hthel
evelofsavi
ngandt
hel
evelofi
nvest
mentwer
efunct
ionsoft
he
i
nter
estr
ate,and when t
hosel
evel
swer
eequal
,theequi
li
bri
um r
ateof
i
nter
estwasdet
ermi
ned.

Keynes’
scr
it
ici
sm
i
) Whi
leKeynesi
ngener
alaccept
edt
hecl
assi
calnot
iont
hatt
he
l
evelofi
nvest
mentcoul
ddependont
hei
nter
estr
ate,hebel
ieved
t
hatt
hel
evelofsavi
ngsi
ntheeconomydi
dnotdependont
he
i
nter
estr
atebutont
hel
evel
ofi
ncome.
I
nKeynes’
sthi
nki
ngi
twast
hel
evelofi
ncomeandnott
hei
nter
est
r
atet
hatbr
oughtt
hel
evelofsavi
ngi
ntoequi
li
bri
um wi
tht
hel
evel
ofi
nvest
ment
.
i
i) Keynesr
eject
edt
hecl
assi
calr
ealt
heor
yofi
nter
esti
nfavorofa
monet
aryt
heor
yofi
nter
est
.

Keynes’
smonet
aryTheor
yofI
nter
est

57
 I
nKeynes’
sanal
ysi
s,i
twast
hedemandf
orandsuppl
yofmoneyt
hatwer
e
i
mpor
tanti
ndet
ermi
ningt
hemar
ketr
ateofi
nter
estandnotast
hecl
assi
cal
economi
stssupposedt
hei
nter
act
ionofsavi
ngandi
nvest
mentschedul
e.
 Keynescombi
nedt
hespecul
ati
vedemandf
ormoneywi
tht
hepor
ti
onoft
he
moneysuppl
ythatwoul
dbeusedbyhousehol
dforspecul
ati
vepur
posest
o
det
ermi
net
hemar
ketr
ateofi
nter
est
.
 Todet
ermi
net
heamountofspecul
ati
vesuppl
yofmoneyi
ntheeconomy,
he
subt
ract
edt
het
ransact
ionsandpr
ecaut
ionar
ysuppl
yofmoney f
rom

t
het
otal
moneysuppl
y

 Thus

 Not
ethatt
hepor
ti
onoft
het
otalsuppl
yofmoneyneededt
omeett
he
househol
dtr
ansact
iondemandwasf
oundbyest
imat
ing

I
f andr
eal

 Si
nceatequi
li
bri
um mustequal ,
 Moneysuppl
yforspecul
ati
vepur
posewoul
dequal

 Thus t
he equi
li
bri
um mar
ketr
ate ofi
nter
estwas det
ermi
ned by t
he
i
nter
act
ionoft
hespecul
ati
vemoneydemandandt
hemoneysuppl
yfor
specul
ati
vepur
poseasshowni
nfi
gur
e4.
3.

one
Fi
gur
e4.
3:TheSpecul
ati
veDemandf
orMoneyandt
heSpecul
ati
veSuppl
yof

58
Money

 Theequi
li
bri
um mar
ketr
ateofi
nter
est i
sdet
ermi
nedbyt
hei
nter
sect
ion

of ,
thespecul
ati
vedemandcur
vewi
th ,
thespecul
ati
vemoneysuppl
y.

 I
fthespecul
ati
vemoneysuppl
yisgr
eat
ert
hant
hespecul
ati
vedemandf
or
money ,househol
dwoul
dbuybondssi
ncet
heyhaveexcess

specul
ati
vebal
ances(
repr
esent
edbydi
stanceAB)ati
nter
estr
ate
 Thepr
iceofbondwoul
dbebi
dup,whi
chwoul
dcauset
hemar
ketr
ateof
i
nter
estt
ofal
ltowar
dst
heequi
li
bri
um r
ateofi
nter
est
, .

 I
fthe specul
ati
ve demand f
ormoney exceeded t
he specul
ati
ve money
suppl
y ati
nter
estr
ate househol
dswoul
dhaveanexcess

specul
ati
vedemandf
ormoney,shownbyt
hedi
stanceCD.Thepr
iceof
bondswoul
dfal
lcausi
ngt
hemar
ketr
ateofi
nter
estt
ori
set
owar
dthe
equi
li
bri
um r
ate .

 Keynescal
ledt
heequi
li
bri
um r
ateofi
nter
estt
hei
nter
estr
ate.
 I
tshoul
dbepoi
ntedoutt
hatKeynest
heor
yofi
nter
estwasani
ncompl
ete
t
heor
ysi
ncei
tinvol
vedonl
yonesi
deoft
heeconomyanddi
dnoti
ncl
udet
he
r
ealsi
deoft
heeconomy.Keynesdi
dnotexpl
ainhowt
heequi
li
bri
um l
evelof
GNPwasdet
ermi
nedi
nhi
stheor
yofi
nter
est
.

59
 Theequi
li
bri
um l
evelofGNPhadt
obeknownt
ofi
nd ,
whi
cht
henenabl
ed

t
heest
abl
ishmentoft
het
otalmoneysuppl
y t
hatwasl
eftf
orspecul
ati
ve
pur
poses.
 I
twasSi
rJohnHi
cksofOxf
ordUni
ver
sit
ywhoputt
her
ealsi
deoft
he
monet
arysi
det
oget
hert
ofor
m agener
alequi
li
bri
um t
heor
yofi
nter
est
.Thi
s
wasi
ntheI
S-LM f
r kt
amewor obecover
edl
ateri
nthecour
se.

MONEYMARKETEQUI
LIBRI
UM
 Moneymar
ketequi
li
bri
um r
equi
rest
hatt
het
otaldemandf
ormoneyequal
t
otalsuppl
yofmoneyi
ntheeconomy.
 Tot
aldemandf
ormoneyi
sexpr
essedas

 Tot
alsuppl
yofmoneyi
sexpr
essedas

Recal
l
: i
str
ansact
ionandpr
ecaut
ionar
ysuppl
yofmoney.

i
sthespecul
ati
vesuppl
yofmoney.

 Ther
efor
e,t
heequat
ionf
ormoneymar
ketequi
li
bri
um woul
dbe:

Or

Der
ivat
ionoft
otalmoneydemandcur
ve

60
 Transact
io
n Specul
ati
ve Tot
almoney
demand demand demand

 Not
ethatt
ransact
iondemandf
ormoneyi
saver
ti
call
ineatagi
venl
evelof
i
ncome,
sincei
tisnotaf
fect
edbyr
ateofi
nter
est
.
 Wheni
ncomei
ncr
easest
o ,sot
hat ,t
otaldemandf
or
moneybecomes

Li
qui
dit
ytr
ap

Equi
li
bri
um i
nmoneymar
ket

61
 Theequi
li
bri
um r
ateofi
nter
esti
s

KEYNES’
SCRI
TISM OFTHECAMBRI
DGEQUANTI
TYTHEORY
 I
nthe Cambr
idge v
ersi
on oft
he quant
it
ytheor
y ,si
nce t
he
t
ransact
i ormoney,k (
onsdemand f ther
eci
procalofi
ncomevel
oci
tyof
money )andt
hef
ullempl putO,wher
oymentout ebot
hconst
ant
s,t
her
e

wasadi
rectandpr
opor
ti
onalr
elat
ionshi
pbet
weent
hemoneysuppl
yand
t
hepr
icel
evel
.
 Ani
ncr
easei
nthemoneysuppl
yonl
yhadanef
fectonpr
ices.I
not
herwor
ds,
moneywasneut
rali
nit
simpactonr
ealout
putO.

Keynes’
scr
it
ics
i
) I
nhi
scr
it
ici
sm oft
hequant
it
ytheor
y,Keynesar
guedt
hatt
her
elat
ionshi
p
bet
weent
hemoneysuppl
yandt
hepr
icel
evelwasnotdi
rectbuti
ndi
rect
.
An i
ncr
ease i
n money suppl
yled t
oincr
ease i
n money suppl
yfor

62
specul
ati
ve pur
pose and hence t
o (
excess specul
ati
ve

bal
ances)
.Wi
th negat
ivel
y sl
opi
ng specul
ati
ve demand cur
ve,such
excessbal
anceswoul
dpr
oduceadecl
inei
nther
ateofi
nter
est
,i.
Decl
inei
nthei
nter
estr
atest
imul
atesbusi
nessesi
nvest
mentspendi
ng,
I,
oncapi
talgoodswhi
chcausesar
isei
nther putofgoodsO.
ealout
Ar
isei
nrealout
puti
ntur
npr
oducesani
ncr
easei
nthemar
ginalcost
s,
i
ncl
udi
ngmoneywager
ate.
I
ncr
easei
ncostl
edt
oar
isei
nthepr
i evelP.Thus,t
cel her
eexi
sted
i
ndi
rectr
elat
i weenM andP.
onbet
Keynes’
sint
roduct
ionoft
hespecul
ati
vemot
ivef
orhol
dingmoneymeant
t
hati
ncomevel
oci
ty, ,
wasnol
ongeraconst
ant
.

Si
ncei
ncomevel
oci
tyi
sthenumberoft
imest
hemoneysuppl
ytur
ned
overperyearagai
nstf
inalgoodsandser
vices,t
hehol
dingandr
eleasi
ng
ofi
dlemoneybal
ancesatvar
ioust
imesdur
ingt
heyearwoul
dcauset
he
vel
oci
tyt
ofl
uct
uat
e.
When househol
ds hol
didl
e money bal
ances,t
he vel
oci
ty oft
hese
specul
ati
vebal
ancesmustbezer
o,causi
ngover
allvel
oci
tyt
ofal
l.
Si
ncet
hespecul
ati
vedemandf
ormoneywaspar
toft
het
otaldemandf
or
money,Keyneswasdemonst
rat
ingt
hatt
het
otaldemandf
ormoney,
,was unst
abl
e whi
let
he cl
assi
caleconomi
sts had

bel
ievedt
hatt
het
otaldemandf
ormoney, ,wasst
abl ncek
esi
wasaconst
anti
ntheshor
trun.

KEYNES’
SCRI
TICI
SM OFWAGEANDPRI
CEFLEXI
BILI
TY
TheCambr
idgeeconomi
stA.C.Pi
gouhadar
guedt
hatsur
plusl
aborwas
causedbyt
oohi
ghar
ealwageabovet
heonewhi
chwoul
dequat
ethe
demandf
orandsuppl
yofl
abor
.
Si
ncet
hedemandf
orandsuppl
yofl
aborwer
ebot
hfunct
ionsoft
her
eal
wage,Pi
gouhadaguedt
hathousehol
dshoul
dtakecut
sint
hei
rmoney
wage,
causi
ngt
hepr
icel
evelt
ofal
llesst
hant
hepr
opor
ti
onal
lyt
othef
all

63
i
nthemoneywageandt
her
ebyr
educi
ngt
her
eal
wage.
Thel
ower
ingoft
her
ealwagewoul
dresul
tinbusi
nesshi
ri
ngmor
elabor
.
Event
ual
ly,ast
her
ealwagecont
inuedt
odecl
ine,t
heeconomywoul
d
r
eachf
ullempl
oyment
.

Keynes’
svi
ew
Thef
oll
owi
ngar
ethef
ourbasi
cpoi
ntsi
nKeynes’
sanal
ysi
soft
hel
abor
mar
ket
.
a.Keynesaccept
edt
hecl
assi
calposi
ti
onont
hedemandcur
vef
orl
abor
.
Hear
gued wi
tht
hemar
ginalpr
oduct
ivi
tyofl
aborconcept
.Thus,

demandf
orl
aborwasaf
unct
ionoft
her
ealwage.Thus,

b.Keynesdi
dnotagr
eewi
tht
hecl
assi
calnot
ionoft
hesuppl
yofl
abor
.
Hewasoft
heopi
niont
hatmoneywagesf
orhousehol
dwer
enot
det
ermi
nedeachdayi
nanauct
ionmar
ketbutwer
epost
edandsetf
or
acer
tai
nper
iodoft
ime,
suchasamont
h,ayear
,orevenanumberof
year
s.Hebel
ieved,t
hen,t
hatwhen househol
d of
fer
ed t
hei
rlabor
ser
vicesf
orhi
re,t
heyl
ookedonl
yatt
hemoneywaget
hatt
heywoul
d
r
ecei
ver
elat
ivet
othemoneywager
ecei
vedbyot
herhousehol
dand
notatt
heabsol
uter
ealwage.Ahousehol
dwoul
dwi
thdr
awf
rom t
he
l
abormar
keti
fit
smoneywagef
ellr
elat
ivet
othemoneywageofot
her
househol
ds.Butt
hehousehol
dwoul
dnotwi
thdr
aw i
fther
ealwage
f
elluni
for
mlyf
oral
lhousehol
ds.
Thussuppl
yofl
abori
saf
unct
ionoft
hemoneywageandcanbe
expr
essedas:
eW i
wher sthemoneywage.

c.Keynesdi
sagr
eedwi
thPi
gou’
spol
icyofr
est
ori
ngt
heeconomyt
oful
l
empl
oymentbyhavi
ngwor
ker
staker
educt
ioni
nthei
rmoneywages.
Keynes’
sar
gumentt
hatt
hesuppl
yofl
abordependedont
hemoney
wages.I
naddi
ti
ont
her
ewasr
esi
stancebyt
radeuni
onst
omoney

64
 wager
educt
ion.Keyneswassuggest
ingt
hent
hatt
hel
abormar
ket
,
especi
all
ythe l
aborsuppl
y mi
ghtnotoper
ate accor
ding t
othe
per
fect
lycompet
it
ivecondi
ti
on.
d.Keynesbel
ievedasdi
dPi
gou,t
hatt
her
ealwagewasabovet
hef
ull
-
empl
oymentequi
li
bri
um r
ealwagedur
ingt
hedepr
essi
onoft
he1930s
andt
hatt
her
ealwagehadt
ober
educedt
orest
oret
heeconomyt
o
f
ullempl
oyment
.Butt
her
eali
ssuesepar
ati
ngt
hem wast
hequest
ion
ofwhatt
ypeofpol
icyshoul
dbeusedt
olowert
her
ealwage.Keynes’
s
cr
it
ici
sm ofPi
gou’
spol
icywasal
ongt
hef
oll
owi
ngl
ines.
i
.Househol
dwoul
dnotacceptar
educt
ioni
nthei
rmoneywage,
butt
heymi
ghtt
akear
educt
ioni
nthei
rrealwagebecauseof
pr
icei
ncr
eases.
i
i.Eveni
foneassumedj
ustf
ort
hesakeofPi
gou’
sar
gumentt
hat
househol
dswoul
dacceptal
owermoneywage,t
her
ewasno
guar
ant
eet
hatpr
iceswoul
dfal
lpr
opor
ti
onat
elyl
esst
hant
he
f
alli
nthemoneywage.I
fpr
icesandwagesf
elli
nthesame
pr
opor
ti
on asKeynesbel
ieved t
her
ealwagewoul
dremai
n
unchanged.

t
wo
Keynes’
svi
ewoft
hel
abormar
ket
 Keynes’
svi
ewoft
hel
abormar
keti
sshowni
nfi
gur
e4. W,
6.Themoneywage,
i
smeasur
edont
hever
ti
calaxi
sandt
heuni
tsofl
abor
,N,ar
edepi
ctedont
he
hor
izont
alaxi
s.

Fi
g4.
6.Keynes’
svi
ewoft
hel
abormar
ket

65
Nomi
nal
(
money)

 Si
ncet
hedemandf
orl
abor i
sani
nver
sef
unct
ionoft
her
ealwage, ,
it

canbedr
awnasaf
unct
i hemoneywage,W,f
onoft orgi
venval
uesoft
he
pr
i evelP.
cel
 Thel
aborsuppl
y, i
sdr
awnpar
all
elt
othehor
izont s,N,becausei
alaxi t

hasnowbecomeaf
unct
ionoft
hemoneywage .

 Att
hemoneywage househol
dsar
ewi
ll
ingt
oof
fert
hei
rser
vicesi
nthe

l
abormar
ketupt
opoi
nt .Beyondpoi
nt , hasaposi
ti
vesl
ope

becauseahi
ghermoneywage mustbeof
fer
edt
oat
tr
actaddi
ti
onal
househol
dint
othel
abormar
ket
.
 Equi
li
bri
um i
nthel
abormar
keti
sest
abl
i ntEwher
shedatpoi ethedemand
f
orl
aborcur
ve i
nter
sectwi
tht
hesuppl
ycur
ve ntEt
.Atpoi her
eis

unempl
oymentofl
aborbyt
heamountof .Not
ethatt
her
ealwage

of i
sabovet
hef
ullempl
oymentequi
li
bri
um r
ealwageof andt
hatt
he

moneywagecannotber
educedbel
owt
hel
evelof .

66
 Si
ncet
her
ealwageof i
stoohi
ghf
ullempl
oyment
,Keynesadvocat
edf
or

t
heuseoff
iscalpol
icyal
ongwi
thmonet
arypol
icy,assumi
ngnol
iqui
dit
y
t
rap,t
o st
imul
ate aggr
egat
e spendi
ng i
nthe economy.Wi
thar
ise i
n
aggr
egat
espendi
ng,
ther
ewoul
dbeagr
aduali
ncr
easei
nthepr
icel
evelf
rom
and woul
dfi
nal
lyst
op at .Thi
spr
icei
ncr
easewoul
d pr
oducea

r
educt
ioni
nther
ealwagef
rom t
o .Atl
owerr
ealwages,busi
ness

begi
ntohi
remor
ewor
ker
s,butatt
hesamemoneywager
ateof .

 Labordemandcur
ve woul
dshi
ftt
other
ightt
o unt
ilf
ullempl
oyment

hasbeenr
eached.Thel
abordemandcur
veof cor
respondst
othef
ull
-

empl
oymentequi
li
bri
um r
ealwageof .

ALTERNATI
VETHEORI
ESOFCONSUMPTI
ON handout
 Pr
ivat
eexpendi
tur
eonconsumpt
ionar
ethel
argestandi
n(aggr
egat
eter
ms
atl
east
)byf
art
hemosti
mpor
tantcomponentoft
otalspendi
ngi
nany
economy
.
 Ther
ear
efourmaj
orhypot
hesesconcer
ningt
hewayi
ncomei
nfl
uences
consumerspendi
ng:
i
) Theabsol
utei
ncomehypot
hesi
s
i
i) Ther
elat
ivei
ncomehypot
hesi
s.
i
ii
) Theper
manenti
ncomehypot
hesi
s
i
v) Thel
if
ecycl
ehypot
hesi
s

 The basi
c quest
ion her
eis whet
her aggr
egat
e consumpt
ion var
ies
pr
opor
ti
onal
lywi
thchangesi
nconsumeri
ncome.Al
lther
ivalhypot
hesesdo
notgi
vet
hesameanswert
othi
squest
ion.

67
THEABSOLUTEI
NCOMEHYPOTHESI
S
 The basi
ctenetoft
he absol
utei
ncome hypot
hesi
sist
hati
ndi
vidual
consumerdet
ermi
nes t
he f
ract
ion ofcur
renti
ncome he wi
lldevot
eto
consumpt
ionont
hebasi
soft
heabsol
utel
evelofi
ncome.
 Al
lel
sebei
ngequal
,ar
isei
nabsol
utei
ncomewi
lll
eadt
oadecr
easei
nthe
f
ract
ionoft
hati
ncomedev
otedt
oconsumpt
ion.
 J.
M.Keyneswast
hef
ir
steconomi
stt
opoi
ntoutt
hisconsumpt
ion–i
ncome
r
elat
ionshi
p.
 Keynes i
dea aboutaggr
egat
e househol
d consumpt
ion expendi
tur
e was
st
atedasf
ourbasi
cpr
inci
ples.
i
) Consumpt
ionC,
isaf
unct
ionofdi
sposabl
eincome
i
i)
i
ii
) Asaggr
egat
erealdi
sposabl
eincome r
ises,t
heaver
age
pr
opensi
t oconsumeAPC,
yt decl
ines.ThusMPC<APC
i
v) Asaggr
egat
erealdi
sposabl
eincomer
isest
hemar
ginal
pr
opensi
tyt
o consume decl
ines,Keynes was t
her
efor
e
i
mpl
yingt
hatt
hef
orm oft
heconsumpt
ionf
unct
ionwoul
d
benonl
inearandnotast
rai
ghtl
ine.

 Not
ethat
:pr
inci
pal
s1 and 2 ar
eessent
ialt
o bui
ld Keynesmodeland
vi
olat
ionof sot
hat woul
dendangert
hest
abi
li
tyoft
he
Keynesi
ansyst
em.
 Keynes’
s pr
inci
pal
s 3 and 4 ar
e not essent
ialt
o Keynesi
an model
const
ruct
ion.TheAPCcanbeei
therl
esst
hanorequalt
otheMPC.
 Al
sot
heconsumpt
ionf
unct
ioncanbel
inearwi
thaconst
antsl
ope(
const
ant
MPC)t
hannonl
inear(
i.
e.t opeorMPCchanges)
hesl .
 Fi
nal
lyt
hef
ir
stt
hreepr
inci
pal
shavebecomeknownast
heabsol
utei
ncome

68
 hypot
hesi
s,whi
ch r
ecei
ved i
tsnamef
rom t
heear
lydi
sci
pleofKeynes.
Absol
utei
ncomemeanst
hati
tiscur
renti
ncomewhi
ch det
ermi
nest
he
amountofhousehol
dconsumpt
ion.

Pr
inci
ples:1
 Keynes st
ressed t
hatr
ealconsumpt
ion was a “
stabl
e”f
unct
ion ofr
eal
di
sposabl
eincome.Thet
erm st
abl
emeans,
forexampl
e,t
hatt
hei
nter
cepta,
andt opeofMPC,Coft
hesl hel
inearconsumpt
ionf
unct
ion, do
notmoveabouti
nunpr
edi
ctabl
emanner
,however
,iti
swor
thpoi
nti
ngout
t
hatKeynes’
shypot
hesi
saboutt
hest
abi
li
tyoft
heconsumpt
ionf
unct
ion
wasbasedoncasualobser
vat
ionr
athert
hanonempi
ri
calevi
dence.I
fthe
consumpt
ionf
unct
ion, ,hadbeenf
oundnott
obest
abl
ebutt
o
behavei
nunpr
edi
ctabl
emanner
,Keynes’
sear
lyf
oll
owercoul
dnothaveused
i
tast
hemaj
orpi
ll
ari
nthei
rtheor
eti
calsyst
ems.

Pr
inci
pal2:
 WasbasedonwhatKeynescal
ledhi
s“f
undament
alpsychol
ogi
call
aw,
”
whi
chwhenpar
aphr
asedmeantt
hathousehol
dwoul
dspendmor
eongoods
andser
vicesasr
ealdi
sposabl
eincomei
ncr
eases,butwoul
dnotconsume
al
loft
hisi
ncr
easei
nrealdi
sposabl
eincome.I
twi
llser
vepar
toft
hisi
ncome
i
ndi
sposabl
eincome.

Reasonswhy
 I
f t
her
ewoul
dbenochangei
nsavi
ngssi
nce
 Consi
der
ingasi
mpl
einvest
mentmul
ti
pli
er

I
f gMPC=2
e.

69
 I
nvest
mentmul
ti
pli
er

 An i
nvest
mentmul
ti
pli
erof-
1 suggest
sthatan i
ncr
easei
ninvest
ment
expendi
tur
es woul
dleadt
oadecl
inei
nnat
ionali
ncomesi
nce woul
d
benegat
ive.Wewoul
dhaveanunst
abl
eeconomy.

fMPC=0
I

 Thi
swoul
dbeat
otal
lyunr
eal
ist
icsi
tuat
ionf
oraneconomysi
ncet
her
e
woul
d be no change i
n consumpt
ion, ,oran i
ncr
ease (
change)i
n
di
sposabl
eincome .
 Ther
ewoul
dbenomul
ti
pli
erpr
ocess

Pr
i pal3:MPC<APC
nci
(
anonpr
opor
ti
onalconsumpt
ionf
unct
ion)
 Keynes’
spr
inci
plewast heAPCdecl
hatt inewi
thr
isi
ngdi
sposabl
eincome.
Thi
spr
inci
plei
mpl
iest
hatt
heconsumpt
ionf
unct
ionwasnon-
propor
ti
onal
,
meani
ngt
hat

MPC<APC
Suppose

eci
Wher sMPC
ai
saut
onomousconsumpt
ion.

70
 I
tisobvi hatMPC<APCatever
oust ylevelofnat
ionali
ncome,
ift
hei
nter
cept
a,i
s gr
eat
ert
han zer
o.Thus we say t
hatl
inearconsumpt
ion i
s non-
pr
opor
ti
onali
fandonl
yift
hei
nt cepta,
er hasaposi
ti
veval
ue.
 I
nthecaseofapr
opor
ti
onalconsumpt
ionf
unct
ion,
thei
nt cepta=0.
er

 The APC doesnotdecl

ine buti
sconst
ant
.Thusa l
inearconsumpt
ion
f
unct
ioni
spr
opor
ti
onali
fthel
evelofconsumpt
ioni
ncr
easesi
nthesame
pr
opor
ti
onast
hel
evelofi
ncome.I
thasazer
oint
erceptval
ue.

THERELATI
VEI
NCOMEHYPOTHESI
S
 JamesDuesenber
ryi
nhi
sbooki
ncome,
savi
ngandt
het
heor
yofconsumer
behavi
or(
1940)
,wasoneoft
hef
ir
steconomi
stst
oof
feramaj
orchal
lenge
t
otheabsol
utei
ncomehypot
hesi
s.
 He pr
oposed an al
ter
nat
ive t
heor
y,of
ten cal
led t
he “
rel
ati
ve i
ncome
hypot
hesi
s” f
or r
econci
li
ng t
he non-
propor
ti
onal(
shor
trun) and t
he
pr
opor
ti
onal(
longr
un)consumpt
ionf
unct
ions.
 Duesenber
ry’
stheor
ywasbasedonar
eject
ionoft
woi
mpl
ici
tassumpt
ions
under
lyi
ngt
hemi
crof
oundat
ionoft
heabsol
utei
ncomehypot
hesi
s.These
ar
e:
i
) That househol
d pr
efer
ence f
or goods and ser
vices wer
e
i
nter
dependent(
noti
ndependent
)
i
i) Thathousehol
dconsumpt
ionexpendi
tur
eswer
eir
rever
sibl
eov
er
t
ime.

71
Fi
rstassumpt
ion:Househol
dpr
efer
encesar
eint
erdependent
 To Duesenber
ry,t
he absol
utei
ncome hypot
hesi
sfai
led t
o consi
dert
he
i
nfl
uencet
hatt
hepsychol
ogi
cal–soci
alenvi
ronmenthadonconsumpt
ion
and savi
ng deci
sions ofhousehol
ds.The f
ocus ofhi
srel
ati
ve i
ncome
hypot
hesi
sis on how a househol
d at
tempt
sto emul
ate ori
mit
atet
he
consumpt
ionbehavi
orofhousehol
dwhosei
ncomei
sjustabovei
tsown.
Thepr
efer
enceofhousehol
dsf
orcer
tai
ntypesofgoodsandser
vicesar
e
af
fect
edbywhatnei
ghbor
sbuy.Thati
s,househol
dhaveat
endencyt
o
consumei
nor
dert
o“keepupwi
tht
heJoneses,
”
 Duesenber
ryal
sopoi
ntsoutt
hatwhenhousehol
dsi
nthei
rever
ydayl
ivi
ng
comes i
ntof
requent cont
act wi
th super
ior goods,t
he r
esul
tsi
sa
“
demonst
rat
ionef
fect
”thi
sef
fectcauseshousehol
dtowantt
ospendsi
nce
t
heydesi
resuper
iorgoodsf
orst
atus.
 However
,keepi
ngupwi
tht
heJonesesandt
hedemonst
rat
ionef
fectmustbe
consi
der
edi
nthecont
extoft
henei
ghbor
hoodi
nwhi
cht
hehousehol
dli
ves.
Forexampl
e,i
fahousehol
dli
vedi
napoornei
ghbor
hood(
say,wi
than
aver
agei
ncomel
evelofKshs50,
000)andr
ecei
vedKshs120,
000ayeari
n
i
ncomei
twoul
dconsumel
essandsavemor
esi
ncei
tsi
ncomewoul
dbe
r
elat
ivel
yhi
ghascompar
edt
otheaver
agei
ncomeofi
tsnei
ghbor
s.Buti
fthe
househol
drecei
ved t
hesamei
ncome(
Ksh 120,
000)and l
ived i
n ar
ich
nei
ghbor
hood(
aver
agei
ncomeKsh300,
000)
,itwoul
dconsumemor
eand
savel
esssi
ncei
tsi
ncomewoul
d ber
elat
ivel
ylow ascompar
ed t
othe
aver
agei
ncomeofi
tsnei
ghbor
s
 Ther
elat
ivei
ncomehypot
hesi
s,t
her
efor
ear
guest
hatt
hef
unct
ion ofa
househol
dsi
ncomedevot
edt
oconsumpt
ionandsavi
ngdependsont
he
l
evelofi
tsi
ncomer
elat
ivet
othei
ncomeofot
herhousehol
dswi
thwhi
chi
t
i
dent
if
iesr
athert
hanont
heabsol
utel
evelofi
tsi
ncome.
 I
fovera numberofyear
stheabsol
utei
ncomel
evelf
oral
lhousehol
d
doubl
ed,t
hei
rrel
ati
veposi
ti
onont
hei
ncomescal
eremai
nsunchangedand
asar
esul
tthef
ract
ionsofi
ncomedevot
edt
oconsumpt
ionandsavi
ngs
APCandAPS)wi
( llbet
hesameandt
heywer
ewhent
hei
ncomel
evelwas

72
 l
ower
.Theabsol
utel
evelofconsumpt
ion and savi
ngsshoul
d,howev
er
i
ncr
easewi
thar
isei
ntheabsol
utel
evelofi
ncome.
 On t
he ot
herhand i
fa househol
ds i
fa househol
d’si
ncome r
emai
ns
unchangedbutt
hei
ncomesofot
herhousehol
dsr
ise,i
tsi
ncomeposi
ti
on
r
elat
ivet
othatoft
heot
herhousehol
dhast
henchanged.Accor
dingt
othe
r
elat
ivei
ncomehypot
hesi
sthedet
eri
orat
ioni
nther
elat
iveposi
ti
onoft
his
househol
d woul
dlead a r
ise i
nfr
act
ion of i
tsi
ncome devot
ed t
o
consumpt
i APC)despi
on( tet
hef
actt
hatt
her
ehasbeennochangei
nthe
absol
utei
ncome.
 Ther
efor
e,wi
th st
eadi
lyr
isi
ng i
ncome i
nthe economy,t
he r
ati
o of

consumpt
ion t
oincome and t
her
ati
o ofsavi
ng t
oincome

wi
llr
emai
nconst
ant
.Thi
smeanst heAPC=MPCandt
hatt hat

heAPS=MPSt
t hust
he“
true”l
ongr
unr
elat
ionshi
pbet
weenconsumpt
ion
andi
ncomei
spr
opor
ti
onal
.Duesenber
ry’
stheor
yhasexpl
ained,t
hent
he
exi
stenceoft
hel
ongr
un(
secul
ar)consumpt
ionf
unct
ion.

 Secondassumpt
ion:consumpt
ionexpendi
tur
ewer
eir
rever
sibl
eovert
ime
 Tobeabl
etoexpl
aint
hisassumpt
ionweneedt
oexpl
ainhow t
her
elat
ive
i
ncomehypot
hesi
saccount
sfort
heshor
trunvar
iat
ioni
nconsumpt
ionover
t
hebusi
nesscycl
e.
 Accor
dingt
oDuesenber
ry,househol
dsf
ormt
hei
rhabi
tandexpect
ati
onon
t
hebasi
soft
hei
rpr
evi
ouspeaki
ncomet
hati
s,t
hehi
ghesti
ncomel
evelt
hey
havebeenabl
etoobt
ainsof
ar.Thei
rconsumpt
ionpat
ter
nisbasedont
his
i
ncome,
andhousehol
ddonotwantt
ogi
vei
tup.
 Whenar
ecessi
onoccur
sint
heeconomy,
ther
eisaf
alli
nhousehol
dincome.
Butwhen t
hisf
alloccur
s,househol
dswi
llat
temptmai
ntai
nthei
rsame
st
andar
dsofl
ivi
ng(
consumpt
ionpat
ter
n)aswhent
hei
ncomewasatpeak
byr
educi
ngt
hei
rsavi
ngs.Thi
smeanst
hati
sonl
yapar
ti
alr
educt
ioni
n
househol
dconsumpt
ion.Consumpt
ionexpendi
tur
eisnotr
ever
sibl
eint
ime,

73
 meani
ngt
hatwi
thadecl
inei
nincome,
consumpt
ionexpendi
tur
efal
l,
butnot
pr
opor
ti
onal
lywi
tht
hef
alli
nincome.I
nfact
,thef
alli
nconsumpt
ionwhen
t
hei
ncomedecl
inesi
sfarl
esst
hant
hei
ncr
easei
nconsumpt
ionwhen
i
ncomei
ncr
eases.
 Fort
her
elat
ivei
ncomehypot
hesi
s,consumpt
ioni
saf
unct
ionoft
her
ati
oof
cur
renti
ncomet
othepr
evi
ouspeakl
evelofi
ncome.

 eci
,wher sconsumpt
ion,Y i
scur
renti
ncomeand i
sthe

pr
evi
ouspeakl
evelofi
ncome.
 Tocl
ear
lyseet
her
elat
ionshi
pweusef
igur
e7.
3.I
ncomei
sshownont
he
hor
izont
alaxi
sandconsumpt
ionont
hever
ti
calaxi
s.

Fi
gur
e7.
3

Consumpt
ion

I
ncome

 r
epr
esent
sthe l
ong r
un consumpt
ion f
unct
ion and and

74
 r
epr
esent
stheshor
trunconsumpt
ionf
unct
ion
 Letussupposet
hat i
sthehi
ghestl
evelofi
ncomet
hathousehol
dint
he

economyhavebeenabl
etoobt
ainupt
othi
spoi
nti
nti
me.Thus, i
s

i
ncomeati
tscycl
ical
peak.
 Nowsupposet
hati
ncomef
allbel
ow duet
oar
ecessi
on.Househol
dsar
e

accust
omedt
oast
andar
dofl
ivi
ngpr
ovi
dedbypeaki
ncomel
evel and

t
heywi
llwantt
otr
ytomai
ntai
nit
.Inor
dert
odot
his,
theybegi
ntodr
awf
rom
t
hei
rsavi
ngs.Thenasi
ncomebegi
nst
ofal
l
,theyhavet
ocutbackont
hei
r
consumpt
ionexpendi
tur
ebutt
heydot
hisasl
it
tl
easpossi
ble.
 Househol
dmoveal
ongt
heshor
trunconsumpt
ionf
unct
ion f
rom poi
ntB

t
opoi
ntAandnotal
ongt
hel
ongr
unconsumpt
ionf
unct
ion
 Consumpt
ionf
all
sbuti
tdecr
easesl
esst
hanpr
opor
ti
onal
lywi
thadecl
inei
n
i
ncome.Savi
ngf
all
smor
ethanpr
opor
ti
onal
lywi
tht
hef
alli
nincome.
 Wi
tht
hef
alli
nincome,
theAPCr
i heAPSdecl
sesandt ines.
 Whenanupswi
ngi
ntheeconomybegi
nsandani
ncomest
art
sri
singagai
n,
househol
dsmoveupt
heshor
trunconsumpt
ionf
unct
ion f
rom poi
ntAt
o

poi
ntB.t
her
eisadecl
inei
ntheAPCandani
ncr
easei
ntheAPS.Househol
ds
ar
e now consumi
ng l
ess t
han pr
opor
ti
onal
ly and savi
ng mor
ethan
pr
opor
ti
onal
ly.
 Oncepoi
ntB,whi
chi
sassoci
atedwi
thpeaki
ncomel
evel
, i
sreached,

househol
dswi
llhaver
egai
nedt
hepr
evi
ousst
andar
dofl
ivi
ng.
 I
fincomecont
inuest
oincr
easebeyond ,househol
dsnol
ongerhavet
o

makeupf
ort
hei
rpr
evi
ousr
educt
ioni
nsavi
ngandwi
llt
her
efor
ebegi
nto
consumemor
eandwi
llt
her
efor
ebegi
ntoconsumemor
eandmor
eal
ong
t
hel
ongr
unconsumpt
ionf
unct
ion
 Howeverwi
thanot
herr
ecessi
onandf
all
ingofi
ncomet
hepr
evi
ouspr
ocess
st
art
sal
loveragai
n.I
nthi
scaset
hehousehol
dconsumpt
ionmovedownt
he
shor
trunconsumpt
ionf
unct
ion f
rom poi
ntDt
oapoi
ntsuchasF.

75
 Oncet
her
ecessi
oni
soverandt
heupt
urnst
art
s,consumpt
ionexpendi
tur
e
wi
llagai
nincr
easewi
thr
isi
ngi
ncome,
from poi
ntFt
opoi
ntD.oncet
henew
peakl
evel i
sagai
nreached,
anyi
ncr
easei
nincomebeyond wi
llcause
househol
d consumpt
ion expendi
tur
eto agai
n shi
ftovert
othel
ong r
un
consumpt
ionf
unct
ion .

 Not
ethatt
heshor
trunconsumpt
ionf
unct
ionshi
ft
supwar
dsf
rom t
o

asar
esul
tofst
eadi
lyr
isi
ngi
ncome.Butwhenanew andhi
gherpeak

l
evelofi
ncomesuchas i
sreached,t
heshor
trunconsumpt
ionf
unct
ion

cannot
,wi
thaf
alli
nincomeshi
ftdownwar
dsandbackt
o .

 Accor
dingt
oDuesenber
ry,“
ther
atchetkeepst
heeconomyf
rom sl
ippi
ng
backal
lthewayandl
osi
ngal
lthegai
nsi
nincomeacqui
reddur
ingt
he
pr
ecedi
ngboom”economi
stsr
efert
othi
sast
he“
rat
chetef
fect
”
 Because oft
he r
atchetef
fecta down t
urni
nthe economy causes
consumpt
iont
omovebackal
ongt
heshor
trunconsumpt
ionf
unct
ionr
ather
t
hanbackdownt
hel
ongr
unconsumpt
ionf
unct
ion.

THEPERMANENTI
NCOMEHYPOTHESI
S
 Accor
dingt
oMi
lt
onFr
iedman,bot
htheabsol
uteandt
her
elat
ivei
ncome
hypot
hesi
s wer
e based on t
he conceptofcur
renti
ncome.However
,
Fr
iedmanr
eject
edt
henot
iont
hathousehol
dconsumpt
ionexpendi
tur
ear
e
dependentoncur
renti
ncomesi
ncef
orhi
m ayearwast
ooshor
tat
imespan
i
nwhi
cht
omakemeani
ngf
ulhousehol
dspendi
ng deci
sion.Fr
iedman’
s
hypot
hesi
s was t
hathousehol
d consumpt
ion was based on per
manent
i
ncome.
 Thusahousehol
d’scur
rentmeasur
ed(
year
ly)i
ncomecanei
therbegr
eat
er
orl
esst
hanahousehol
dper
manenti
ncome.Her
eper
manenti
ncomer
efer
s
t
oincomet
hatahousehol
dant
ici
pat
esorexpect
stor
ecei
veoveranumber
ofyear
sint
hef
utur
e,possi
blyal
if
eti
me.Eachhousehol
dar
ri
vesatan

76
 appr
oxi
mat
ionofi
tsper
manenti
ncomeont
hebasi
sofi
tst
otalweal
th,
humanandnonhuman.
 Thehumanweal
thpar
toft
otalweal
th(
humancapi
tal
)ist
heski
ll
sand
educat
ion t
rai
ning oft
he househol
d appl
ied i
n a cer
tai
n occupat
ion t
o
pr
oduceaf
lowofi
ncome.
 Thenonhumanweal
thi
sther
ealphysi
calandf
inanci
alasset
sownedbyt
he
househol
d.
 Eachhousehol
dlooksaheadasbestasi
tcanandder
ivesest
imat
esoft
he
st
reamsofi
ncomet
ober
ecei
vedf
rom humanandnonhumancapi
tal
.The
sum oft
hepr
esentdi
scount
ed val
uesoft
heset
wo st
reamsofi
ncome
const
it
utest
hehousehol
d’scur
rentweal
th.
 Fr
iedmandi
videdt
hehousehol
d’smeasur
edyear
lyi
ncomei
ntoper
manent
andt
ransi
tor
ycomponent
s,sot
hati
tsmeasur
edi
ncomei
slar
gerorsmal
ler
t
hani
tsper
manenti
ncome,dependi
ngont
hesum ofposi
ti
veandnegat
ive
t
ransi
tor
yincomecomponent
.


e Y,
 Wher and r
epr
esentmeasur
ed per
manentand t
ransi
tor
y

component
srespect
ivel
y.
 Tr
ansi
tor
yincome r
esul
tsf
rom al
lthosef
act
orst
hatt
hehousehol
d

consi
der
spur
echanceorunexpect
ed.
 I
fhousehol
dexper
iencegoodl
uck andi
fithasbadl
uck

 Ther
efor
e

 Fr
iedmanassumedt
hatal
lposi
ti
vet
ransi
tor
yincomei
ssaved.
 When measur
edi
ncomeYwoul
dbegr
eat
ert
han

 Ont
heot
herhand,
negat
ivet
ransi
tor
yincomei
sdesavi
ng.

77
 Thel
if
ecycl
ehypot
hesi
s
1. Li
feCycl
eIncomeHypot
hesi
s

Thi
s hypot
hesi
s was f
ormul
ated by Modi
gli
ani
,Ando and Br
umber
g.I
tis
t
her
efor
eal
socal
ledt
heMBAhypot
hesi
s.
I
tst
atest
hatconsumpt
ioni
saf
unct
ionoft
heexpect
edst
ream ofdi
sposabl
e
i
ncomeoveral
ongper
iodoft
imeandt
hepr
esentval
ueofweal
th.
I
ndi
vidual
sar
eassumedt
ospr
eadoutt
hepr
esentval
ueofal
lfut
urei
ncome
st
reamsonconsumpt
iont
hroughoutt
hei
rli
fet
ime.Ther
efor
e,consumpt
ioni
s
assumedt
obeaf
unct
ionofl
if
eti
mei
ncome.

Gr
aphi
cal
lyt
hisi
sshownasf
oll
ows:

C,
S,Y

C
S>0,
Netsaver S<0,
Netdi
s-saver

S<0,
Netbor
rower

0 Ti
me(
Year
s)

Wher
e C=Consumpti
on
Y =I
ncome
S =Savi
ngs

78
When,
C>Y,
thei
ndi
viduali
sbor
rowi
ngt
oconsumeandbui
lduphumancapi
tal
;
Y>C,t
hei
ndi
viduali
spayi
ngl
oansandsavi
ngf
orf
utur
econsumpt
ion,
i
nvest
ment
and f
or bequest
s;andwhen
C >Y,t
hei
ndi
viduali
sconsumi
ngoutofsavi
ngs,pensi
onandsoci
al
secur
it
y
f
und.

Accor
ding t
othe l
if
e cycl
eincome hypot
hesi
s,t
he aver
age pr
opensi
tyt
o
consume(
APC)i
shi
ghi
ntheear
lyandl
ateyear
sofani
ndi
vidual
’
sli
fe.Thi
sis
whyt
her
eisnon-
propor
ti
onal
it
yini
ncomeandconsumpt
ionr
elat
ionshi
pint
he
shor
trun.I
nthel
ongr
unhowever
,consumpt
ionandi
ncomer
elat
ionshi
pwi
llbe
pr
opor
ti
onal
.

79
 Ot
herDet
ermi
nant
sofConsumpt
ion
1. Rat
eofI
nter
est
:Accor
dingt
ocl
assi
caleconomi
sts,i
ndi
vidual
swi
llsave
mor
e andspendl
essasi
nter
estr
atei
ncr
eases
2.Rel
ati
vePr
ices: Thi
sinf
luencesconsumpt
ionbehavi
ourwi
thconsumer
s
shi
ft
ingt
orel
ati
vel
ycheapergoods.
3. Capi
tal
gai
ns:Accor
dingt
oKeynes,wi
ndf
allgai
ns/
losseswi
lli
nfl
uenceconsumpt
ion.
Keynesar
guedt
hatconsumpt
ionofweal
thowner
scanbei
nfl
uencedbysudden
changesi
nthemoneyval
ueoft
hei
rweal
th.Suddenchangesar
ecommon
wher
ethest
ockexchangemar
keti
scomposedofspecul
ator
s.
4. Weal
th:
Hi
ghst
ocksofweal
thl
eadt
olow mar
ginalval
ueofweal
thandhencel
ess
desi
ret
oaccumul
atemor
e.Asar
esul
t,t
hisl
eadst
oincr
easedconsumpt
ion.
5. Money
st
ock(
Liqui
d asset
s):Thehi
ghert
hest
ockofl
iqui
d asset
sthehi
ghert
he
mar
ginalpr
opensi
tyt
oconsume.
6. Avai
labi
li
t
yofconsumercr
edi
t:Readi
lyavai
labl
eand/
orcheapconsumercr
edi
tleadst
o
consumer
sbor
rowi
ngf
orconsumpt
ionpur
poses.Thi
spushesupt
heaggr
egat
e
consumpt
ionf
unct
ion.
7. At
ti
tudes
and Expect
ati
ons ofConsumer
s:Bot
h change i
n consumerat
ti
tudes and
expect
ati
onsaf
fectt
hei
rconsumpt
ionbehavi
our
.Iff
ori
nst
ance,consumer
s
expectapr
icei
ncr
easeofacer
tai
n good,t
heymayi
ncr
easet
hei
rcur
rent
pur
chaseoft
hesamegood.
8. Money
I
ll
usi
on:Consumpt
ionwi
llgoupwhenconsumer
ssuf
ferf
rom moneyi
ll
usi
on.
Money i
ll
usi
on occur
s when consumer
sfai
ltor
eal
ize t
he pr
ice i
ncr
ease
accompanyi
ng t
he i
ncr
ease i
nthei
rnomi
nali
ncome,t
her
eby behavi
ng as
t
hought
hei
rreali
ncomehasi
ncr
easedwheni
thasnot
.Moneyi
ll
usi
oni
sal
so

80
cal
ledPi
gouorr
ealcashbal
anceef
fect
.
9. Di
str
ibut
i
onofI
ncome:Redi
str
ibut
ionofi
ncomemaycauseashi
fti
ntheaggr
egat
e
consumpt
ionf
unct
ion,orl
eadt
obot
hashi
ftt
oachangei
nthesl
opeoft
he
f
unct
ion.I
tther
efor
e af
fect
sthe l
evelofaggr
egat
e consumpt
ion,i
fthe
r
eci
pient
s have di
ff
erent mar
ginalpr
opensi
tyt
o consume and aver
age
pr
opensi
tyt
oconsume.
10. Composi
ti
on ofPopul
ati
on:Popul
ati
on composi
ti
on i
nter
ms ofage,sexand cl
ass
det
ermi
nesconsumpt
ion.

81
 CHAPTERFOUR
TWO-
MARKETEQUI
LIBRI
UM:THEI
S-LM APPROACHTO
AGGREGATEDEMAND
 Ourai
mint
hischapt
eri
stoi
ntegr
atet
hemoneyandcommodi
ti
esmar
ket
,
wi
thpr
imar
yemphasi
sont
hemechani
csoft
hei
rint
eract
ion.Weal
soshow
howal
ter
nat
ivepossi
blei
nter
act
ionsbet
weenmoneyandcommodi
ti
esmay
af
fectcr
uci
almacr
oeconomi
csvar
iabl
essuchasi
ncome(
andi
mpl
ici
tl
y,
empl
oyment
)andt
her
ateofi
nter
est
.Weconsi
dert
hepossi
bleef
fect
sof
f
iscalandmonet
arypol
icy,
thef
undament
alt
ool
sofeconomi
csst
abi
li
zat
ion.

EQUI
LIBRI
UM I
NTHEREALSECTOR:THEI
SCURVE
 Wedevel
op acommodi
ti
esmar
ketequi
li
bri
um f
unct
ion cal
led t
heI
S or
i
nvest
ment
-savi
ngf
unct
ion.I
nthedevel
opmentoft
heI
Smodelt
hei
nter
est
r
atei
sal
lowedt
ovar
yandt
oef
fecti
nvest
ment
.

Wher
e

 Thi
scondi
ti
onmeanst
hati
nvest
mentwi
lli
ncr
easeasi
nter
estr
atef
alland
vi
cever
sa.
 I
nit
ial
lyweassumet
hatt
heeconomyi
scl
osed,excl
udi
ng,t
her
efor
e,t
he
f
orei
gnt
radesect
or.
 I
nthel
atersect
ion,
however
,thi
sassumpt
ionwi
llber
elaxedandt
heef
fectof
f
orei
gnt
radesect
oronI
S-LM modelbeexami
ned.
 Thef
iscalsect
or-gover
nmentexpendi
tur
eandt
axat
ioni
nincl
udedi
ntot
he
modelwhender
ivi
ngt
heI
Smodel
.

Const
ruct
ingt
heI
Sfunct
ion
 Recal
lthati
nthe pr
evi
ous chapt
er,equi
li
bri
um i
nthe goods mar
ket
compr
isi
ngconsumer
,invest
orandgover
nmentsect
orr
equi
redt
hat

82
 I
nfi
gur
e8.
1weder
ivedt
heI
Scur
ve
Fi
gur
e8.
1:Equi
li
bri
um i
nthegoodsmar
ket

n panela,wi
 I thi
nter
estr
ate equi
li
bri
um i
ncomei
satl
evel si
nce

l
eakagesequal
inj
ect
ionatt
hati
ncomel
evel .

 Howeveral
oweri
nter
estr
ate wi
lli
ncr
easei
nvest
mentspendi
ngandshi
ft

t
o .I
ncomewi
llr
isef
rom t
o .

 Si
mil
arl
yahi
gheri
nter
estr
ate wi
llcause t
oshi
ftdownwar
dst
o

,
resul
ti
ngi
nal
oweri
ncomel
evel .
 Thei
nver
ser
elat
ionshi
pbet
weent
hei
nter
estr
ateandi
ncomei
spl
ott
edon
t
heI
Scur
vei
npanel(
b),whi
chshowst
hevar
iouscombi
nat
ionofiandY
t
hatpr
oduceequi
li
bri
um i
nther
ealsect
or.
 I
ftheeconomyi
ssi
tuat
edt
other
ightoft
heI
Scur
ve(
suchasatpoi
ntRi
n
panelb)
,thendi
sequi
li
bri
um exi
stsbecause .Thei
ncomel
evel
i
s“t
oohi
gh”f
ort
heassoci
atedi
nter
estr
ateandt
hehi
ghi
ncomel
evel“
too

83
 much”savi
ngandt
ax.Al
ter
nat
ivel
y,f
ort
hei
ncomel
evelassoci
atedwi
thR,
t
hei
nter
estr
atei
stoohi
ghandi
sthuschocki
ngof
finvest
ment
.Incomewi
ll
f
allunt
ilt
heI
Scur
vei
sreachedt
hroughcutbacksofpr
oduct
ionbecauseof
uni
ntendedi
nvent
oryaccumul
ati
onatt
hehi
gherl
evelofi
ncome.
 Tot
hel
eftoft
heI
Scur
ve,suchasatpoi
ntU, andt
her
eis
upwar
dspr
essur
eont
hei
ncomel
evel
.

Whatcausesshi
fti
ntheI
Scur
ve?
Anychangei
naut
onomousi
nvest
ment
,gover
nmentexpendi
tur
e,t
axes,and
savi
ngswi
lldoso.
Ani
ncr
easei
naut
onomousi
nvest
ment(
duet
osomet
hingot
hert
hanaf
alli
n
t
hei
nter
estr
ate)andgover
nmentexpendi
tur
eoranaut
onomousdecr
easei
n
savi
ngsandt
axeswi
llshi
ftt
heI
Scur
vet
other
ight
.Ont
heot
herhand,an
aut
onomousdecr nIorGoranaut
easei onomousi
ncr nSandTwi
easei llshi
ft
t
heI
Scur
vet
othel
eft
.

GENERALEQUI
LIBRI
UM I
NTHEMONEYMARKET:THELM CURVE.
I
nthe ear
li
er chapt
ers,we der
ived t
he Keynesi
an money demand and
equi
li
bri
um i
nthemoneymar
ketbyequat
ionmoneydemandt
omoneysuppl
y.

Fi
gur
e8.
2:Equi
li
bri
um i
nthemoneymar
ket

84
 Thef
ixedmoneysuppl
yisi
ndi
cat
edbyt
hever
ti
call
ine .Thedemandf
or

moneyi
srepr
esent
edbyt
he cur
veandi
sthesummat
ionofspecul
ati
ve

moneydemand and moneydemand f

ort
ransact
ion mot
ives .

Equi
li
bri
um i
nter
estr
atei
s

 I
tiswor
thnot
ing,howevert
hatt
heaboveanal
ysi
sfocusesont
hei
nter
est
r
ateandequi
li
bri
um bet
weent
hedemandandsuppl
yofmoney.Butt
hisi
s
onl
yapar
ti
alanal
ysi
sbecausei
thasnegl
ect
edt
heot
hermai
ndet
ermi
nant
ofmoney–t
hel
evelofi
ncomei
ntheeconomy.Wenowi
ntr
oducet
her
oleof
i
ncome i
n moneymar
ketequi
li
bri
um.The l
evelofi
ncome i
s posi
ti
vel
y
associ
atedwi
tht
hedemandf
ormoney.

Const
ruct
ionofLM cur
ve

Fi
gur
e8.
3:TheLM cur
ve

85
 I
npanel(
a),
ani
ncr
easei
nincomef
rom t
o wi
lli
ncr
easet
hedemandf
or

moneyf
rom t
o andwi
llr
esul
tinar
isei
nthei
nter
estr
atef
rom

t
o

 Adecr
easei
nincomef
rom t
o wi
lldecr
easet
hedemandf
ormoney

f
rom t
o andl
eadt
oaf
all
int
hei
nter
estr
atef
rom t
o .

 Thi
sposi
ti
ver
elat
ionshi weenYandii
pbet spor
trayedbyt
heLM cur
vei
n
panel(
b).TheLM cur
veshowst
hevar
iouscombi
nat
ionsofi
ncomeandt
he
i
nter
estr
atet
hatyi
eldequi
li
bri
um i
nthemoneymar
ket
.
 Not
ethatatt
hel
owesti
nter
estr
ateLM cur
vei
shor
izont
al.Thehor
izont
al
por
ti
oni
ll
ust
rat
est
hel
iqui
dit
ytr
ap.
 Anypoi
ntt
other
ightofLM cur
ve,suchaspoi
ntT,i
sassoci
atedwi
than
excessdemandf
ormoney .Atsuchapoi
nt,t
hei
nter
estr
atei
stoo

l
owf
ort
hei
ncomel
evel
.Equi
li
bri
um i
nthemoneymar
ketr
equi
resahi
gher.
 Si
mil
arl
yanypoi
ntt
othel
eftoft
heLM cur
ve,suchaspoi
ntV,i
nvol
vesan
excessmoneysuppl
y .Fort
hei
ncomel
evelassoci
atedwi
thV,t
he

86
 i
nter
estr
ateneedst
obel
oweri
nor
dert
ohaveequi
li
bri
um i
nthemoney
mar
ket
.

Whatcausesshi
fti
nLM?
 I
ncr
easesi
nthedemandf
ormoney(
duet
oot
hert
hingsbesi
desar
isei
n
i
ncome)ordecr
easesi
nthesuppl
yofmoneywi
llshi
ftt
heLM cur
vet
othe
l
eft
.Inei
thersi
tuat
ion,t
hei
nter
estr
ater
isesf
oranygi
veni
ncomel
evel
,
whi
chi
sanal
ogoust
osayi
ngt
hatt
hei
ncomel
evelmustf
alli
nor
dert
o
mai
ntai
nthesamei
nter
estr
ate,t
huseachi
nter
estr
atei
spl
ott
edagai
nsta
l
oweri
ncomel
evelt
hanbef
oret
hei
ncr
easei
nthedemandf
ormoneyort
he
decr
easei
nthesuppl
yofmoney.
 Byr
ever
ser
easoni
ngdecr
easei
nthedemandf
ormoney(
duet
oot
hert
hings
besi
desaf
alli
nincome)andi
ncr
easei
nthesuppl
yofmoneywi
llshi
ftt
he
LM cur
vet
other
ight
.

Fi
gur
e8.
4

87
SI
MULATANI
USEQUI
LIBRI
UM I
NTHEMONETARYANDREAL(
GOOD)SECTOR
 Equi
li
bri
um occur
swher
etheLM andt
heI
S cur
vesi
nter nte,
sectatpoi
gi
vingt
hei
ncomel
evel andt
hei
nter
estr
atei
.e.asshowni
nfi
gur
e8.
5.

Fi
gur
e8.
5:Equi
li
bri
um i
ntheRealandMonet
arySect
or

 I
ftheeconomyi
ssi
tuat
edawayf
rom poi
ntF,
sincewear
etot
her
ightoft
he
I
Scur
ve,
then ,
ther
ewi
llbecont
ract
ionar
ypr
essur
eont
hel
evel

88
 ofi
ncome.Butsi
ncewear
eal
sot
other
ightoft
heLM cur
ve,
thedemandf
or
moneyexceedst
hesuppl
yofmoneyandt
her
efor
ethei
nter
estr
atewi
llr
ise.
Thesef
orceswi
llevent
ual
lymovet
heeconomyt nte.
opoi
 Fi
gur
e8.
6summar
izest
headj
ust
ment
sordi
rect
ionalchangesi
nint
erest
r
atesandi
ncomer
esul
ti
ngf
rom di
sequi
li
bri
um f
orcesi
nbot
hpr
oduct
sand
moneymar
ket
.

Fi
gur
e8.
6:Adj
ust
mentMechani
sm

FI
SCALANDMONETARYPOLI
CYI
NTHEI
S-LM FRAMEWORK
 Usi
ngt
heI
S-LM f
ramewor
k,wewi
llbecompar
ingt
heef
fectoff
iscaland
monet
arypol
icyont
hei
ncomel
evelandt
hei
nter
estr
ateundert
het
hree
r
angesoft
heLM f
unct
ion.
 Wi
thaf
ixedmoneysuppl
y,t
heLM f
unct
ionsasder
ivedi
nfi
gur
e8.
3sl
opes
upwar
dst
other
ight
.
 Howeveratoneext
remet
hef
unct
ionmaybecomeper
fect
lyel
ast
ic,andat
t
heot
herext
remei
tmaybecomeper
fect
lyi
nel
ast
ic.Wi
thar
angeofvar
ying
el
ast
ici
ti
esi
nbet
ween.Theset
hreer
angesar
edef
inedi
nfi
gur
e8.
7inwhi
ch
t
heper
fect
lyel
ast
icsect
ioni
sthe“
Keynesi
anr
ange”t
heper
fect
lyi
nel
ast
ic
sect
ioni
sthe“
classi
calr
ange”andt
hesect
ionbet
weeni
sthei
nter
medi
ate

89
 r
ange.

Fi
gur
e8.
7:LM f
unct
ion’
sthr
eer
anges

 Whyar
ethet
hreesect
ionsi
ntowhi
cht
heLM f
unct
ionhasbeendi
vided
l
abel
edi
nthi
sfashi
on?
 I
nthesi
mpl
if
iedver
sionoft
hecl
assi
calt
heor
ymoneyi
sdemandedonl
yfor
t
ransact
ions pur
pose. Ther
efor
e cl
assi
cal t
heor
y assumes t
hat t
he
specul
ati
vedemandf
ormoneyi
szer
oateachi
nter
estr
ate.Thati
swhyat
t
hehi
ghesti
nter
estr
ateLM i
sper
fect
lyi
nel
ast
ic.Weal
th-
hol
der
sbel
ievet
he
i
nter
estr
atewi
llr
isenohi
gherandt
hatsecur
it
ypr
iceswi
llf
allnol
owerand
asar
esul
ttheypr
efert
ohol
donl
ysecur
it
iesandnoi
dlecash.
 Att
heot
herext
remeatsomever
ylowi
nter
estr
atet
hespecul
ati
vedemand
f
ormoneybecomesper
fect
lyel
ast
icsi
ncet
hei
nter
estr
atewi
llf
allnol
ower
andsecur
it
ypr
iceswi
llr
isenohi
gher
.Int
hiscaseweal
thhol
der
spr
efert
o
exchangesecur
it
iesf
orcashatexi
sti
ngsecur
it
ypr
ices,whi
chpr
oducest
he
l
iqui
dit
ytr
apont
hespecul
ati
vedemandf
unct
ion.Ont
heLM f
unct
ion,i
t
pr
oduceswhati
sknownast
heKeynesi
anr
ange.

EFFECT OF THE FI
SCAL POLI
CY I
N THE THREE RANGES OF THE LM

90
FUNCTI
ON
TheKeynesi
ancase
 I
mposi
ti
onoff
iscalpol
icy(
incr
easedgover
nmentexpendi
tur
eorr
educt
ion
oft
axes)shi
ft
stheI
Scur
veout
war
ds.I
ntheKeynesi
anr
ange,t
hef
iscal
pol
icyi
sver
yef
fect
ivesi
nceout
puti
ncr
easesf
rom t
o ,
wit
hnochanges

i
nthei
nter
estr
ate.Bor
rowi
ngbygover
nmentt
ofi
nancet
hedef
ici
ttakes
pl
aceataconst
anti
nter
estr
ate, t
her
eisnocr
owdi
ngoutofi
nvest
ment
.

Thecl
assi
calcase
 Thef
iscalpol
icyi
spower
less.Ashi
fti
nISduet
oani
ncr
easei
ngover
nment
spendi
ng f
rom t
o overt
hever
ti
calsect
ion ofLM pr
oducesno

changesi
nint
erestr
ates.
 Gi
vent
hecl
assi
calassumpt
iont
hati
nvest
mentdemandf
unct
ioni
shi
ghl
y
i
nter
estel
ast
ic,t
her
isei
nint
erestr
atesr
esul
ti
ngf
rom f
iscalexpansi
on
r
educesorcr
owdsoutpr
ivat
einvest
mentand consumpt
ion,l
eavi
ng no
changei
ntot
alspendi
ngandt
her
efor
enochangei
nincome.

Thei
nter
medi
atechange
 Amor
ereal
ist
icr
angeofi
nter
medi
atei
nter
sect
ionexi
stswher
efi
scalpol
i
cy
i
s ef
fect
ive.Ther
eis some cr
owdi
ng outofpr
ivat
einvest
ment
,whi
ch
r
educesef
fect
ivenessoff
iscal
pol
icy.

EFFECTSOFTHEMONETARYPOLI
CYI
NTHETHREERANGESOFTHELM.
 Ani
ncr
easei
nmoneysuppl
yshi
ft
sdownt
heLM f
rom t
o as
showni
nfi
gur
e8.
8bel
ow

Fi
gur
e8.
8:Ef
fect
sofmonet
arypol
icy

91
TheKeynesi
ancase
 Monet
arypol
icyi
sut
ter
lyhel
pless.Ani
ncr
easei
nthemoneyst
ock,gi
vena
r
elat
ivel
yel
ast
icI
Sfunct
ion, ,mer
elyext
endst
hel
iqui
dit
ytr
ap,l
eavi
ng

t
hei
nter
estr
ate unal
ter
ed.Nonew i
nvest
mentwi
llbef
ort
hcomi
ngi
nthe

economyi
fthei
nter
estr
atecannotbepusheddownwar
ds.Thus,ext
reme
Keynesi
anr
egar
dmonet
arypol
icyast
heor
eti
cal
lyandpr
act
ical
lyi
nef
fect
ual
asameansofst
imul
ati
ngi
ncome,
empl
oyment
,oreconomi
cact
ivi
ti
es.

Thecl
assi
cal(
monet
ari
st)case
 Monet
ari
stspl
acedgr
eatemphasi
sonmonet
arypol
icy.Gi
vent
hecl
assi
cal
assumpt
ionst
hati
nvest
mentexpendi
tur
esar
ehi
ghl
ysensi
ti
vet
ochangesi
n
t
her
ateofi
nter
est
,expansi
onar
ymonet
arypol
icyt
hatdecr
easest
hei
nter
est
r
ate woul
d br
ing about l
arge i
ncr
eases i
n i
nvest
ment expendi
tur
es,
i
ncr
easi
ngt
hei
ncomel
evelf
rom t
o .

Thei
nter
medi
ater
ange

92
 Ef
fect
ivenessofmonet
arypol
icyi
ssubj
ectt
otheel
ast
ici
tyoft
heI
Sfunct
ion.
I
nthe case ofa per
fect
lyi
nel
ast
ic i
ncr
ease i
n moneysuppl
yonl
y
decr
easest
hei
nter
estr
atebutl
eavest
hei
ncomel
evelunaf
fect
ed.
 However
,wher
eISi
sel
ast
ic,asi
nthecaseof ,t
hemonet
aryexpansi
on

l
eadst
oreduct
ioni
nint
erestr
ateandi
ncr
easei
nincomel
evelf
rom t
o

 Att
hei
nter
medi
ater
angebot
hfi
scal
andmonet
arypol
icyar
eef
fect
ive.

93
 CHAPTERFI
VE
THEOPENECONOMY
EXCHANGEMARKETS,
BALANCEOFPAYMENTANDMARKET
ANALYSI
S:THEI
NTERNATI
ONALSETTI
NG

I
NTRODUCTI
ON
 I
nthi
schapt
erwer
elaxt
heassumpt
iont
hatt
heeconomywhi
cht
rades
goodsandser
vicesandexchangesasset
swi
thf
orei
gncount
ri
es.Webegi
n
bydi
scussi
ngt
hef
orei
gnexchangemar
ket
.At
tent
ioni
sgi
vent
obot
hfi
xed
andf
lexi
bleexchanger
ates.Weext
endt
heI
S-LM modelbyi
ncl
udi
ngt
he
f
orei
gnt
radesect
or.
 Abal
anceofpaymentf
unct
ioni
sdevel
opedandi
ntr
oducedi
ntoanI
S-LM
modelf
oranopeneconomy.Thi
smodi
fi
edmodeli
sthenusedt
oanal
yze
i
mbal
ancesi
nthebal
anceofpaymentunderani
nter
nat
ionalsyst
em off
ixed
andf
lexi
bleexchanger
ates.

THEFOREI
GNEXCHANGEMARKET
 Whenci
ti
zensofonecount
rywantt
otr
adewi
thci
ti
zensofanot
hercount
ry,
t
hef
ormermustconv
ertt
hei
rcur
rencyi
ntot
hecur
rencyoft
heot
hercount
ry.
I
fU.
S.t
our
istvi
sit
sKenya,
forexampl
etheymustconver
tdol
lar
sint
oKenyan
shi
ll
ingsbef
oret
heycanpur
chasemer
chandi
sef
rom Kenyanci
ti
zens.Thi
s
exchangeofcur
renci
est
akespl
acei
nthef
orei
gnexchangemar
ket
.

Def
ini
ti
onofexchanger
ate
 Anexchanger
atei
sthepr
iceofonecur
rencyi
nter
msofanot
hercur
rency
 e.
g.$1=Ksh.71
 Supposet
heexchanger
atebet
weenU.
S.dol
lar
sandt
heKenyanshi
ll
ing
changesf
rom $1=Ksh.71t
o$1=Ksh.65whatdoest
hisi
mpl
y?
 Thi
simpl
iest
hatt
heval
ueofdomest
iccur
rencyhasi
ncr
eased(
appr
eci
ated)
.
Anappr
eci
ati
onoft
hedomest
iccur
rencymakest
heKenyangoodspr
ice

94
 i
ncr
easei
ndomest
iccur
rencyt
erms.A$100woul
dini
ti
all
ybygoodswor
th
Ksh,
7100butnowi
tcanonl
ybuygoodswor
thKsh6500.

Def
ini
ti
on:appr
eci
ati
on oft
hedomest
iccur
rencyi
sar
isei
nthepr
iceof
domest
iccur
rencyi
nter
msofaf
orei
gncur
rency.

 Al
ter
nat
ivel
yifexchanger
atechangesf
rom $1=Ksh.71t
o$1=Ksh.80,i
t
i
mpl
ies t
hatt
he val
ue ofdomest
ic cur
rencyhas decl
ined (
depr
eci
ated)
agai
nstt
hedol
lar
.Domest
icgoodsar
echeapert
hanbef
ore.Wi
th$100t
he
USci
ti
zenswoul
dbuygoodswor
thKsh8000i
nst
eadofKsh7,
100.

 Def
ini
ti
on:depr
eci
ati
onoft
hedomest
iccur
rencyi
sadecl
inei
nthepr
iceod
adomest
iccur
rencyi
nter
msofaf
orei
gncur
rency.

FLEXI
BLEVsFI
XEDEXCHANGERATE
 Fl
exi
bleexchanger
ate:undert
hei
nter
nat
ionalsyst
em off
lexi
bleexchange
r
ates,t
heexchanger
atei
sdet
ermi
nedbyt
hef
orcesofdemandandsuppl
y
f
orf
orei
gnexchange.Thi
sist
osayt
hatf
lexi
bleexchanger
atesf
oll
ow f
ree
mar
ketf
orces.
 Toi
ll
ust
rat
ethef
orei
gnexchangemar
ket
sassumet
radebet
weenUSand
Kenya.Thatal
loft
hei
reconomi
ctr
ansact
ionsar
edenomi
nat
edi
nUSdol
lar
s.
I
nfi
gur
e9.
1,t
heex
changer
ateE,i
sexpr
essedi
nnumberofKshperUS
dol
larandi
spl
ott
edont
hever
ti
calaxi
s.Thenumberofdol
lar
sispl
ott
edon
t
hehor
izont
alaxi
s.

95
Fi
gur
e9.
1:For
eignExchangeMar
ket

 TheDD cur
vei
sthedemandf
orUSdol
lar
sbyKenyanci
ti
zenswhouse
dol
lar
sfori
mpor
tsf
rom US.Thi
sdemandcur
vehasnegat
ivesl
opebecause
adecl
inei
nthenumberofKshsper$makesdol
lar
slessexpensi
vet
o
Kenyanci
ti
zenscausi
ngt
hem t
oimpor
tlar
gerquant
it
iesofUSgoodsand
ser
vices.
 TheSScur
veshowst
hesuppl
yof$andi
sder
ivedont
hebasi
soft
he
demand f
orKenyan expor
tsi
n US.Thi
sSS cur
vehasa posi
ti
vesl
ope
becauseani
ncr
easei
nthenumberofKsh/
$meanst
hatUSci
ti
zenswi
llbe
wi
ll
ingandabl
etoobt
ainmor
eKsh/
$inf
actKenyangoodsar
elesscost
ly
wi
thar
isei
ntheexchanger
ate(
depr
eci
ati
onoft
heKsh)
 Thef
orei
gnexchangemar
keti
sinequi
li
bri
um atpoi
ntG wher
eDD cur
ve
i
nter
sectt
heSScur
ve(
equi
li
bri
um exchanger
ateequal
sKsh71/dol
lar
)
 Supposet
hatt
heex
changer
atewer
eKsh80/
$1,t
her
ewoul
dbeanexcess

96
 suppl
yofdol
lar
s,shownbyt
hedi
stanceAB.
 Ther
ewoul
dbepr
essur
eint
hemar
ketf
ort
heexchanger
atet
ogodown
(
Ksht
oappr
eci
ateort
hedol
lart
odepr
eci
ate)t
otheequi
li
bri
um.
FI
XEDEXCHANGERATE
 Underani
nter
nat
ionalsyst
em off
ixedexchanger
ate,
eachcount
rychooses
af
ixed val
ue f
ori
ts cur
rencyand cent
ralbankmai
ntai
ns t
hatr
ate by
i
nter
vent
ioni
nthef
orei
gnexchangemar
ket
.
 Af
ixedexchanger
atei
snotor
dinar
yasequi
li
bri
um exchanger
ate.

Demonst
rat
ionofhowf
ixedr
atesar
esust
ained
 Supposet
hatt
heKenyangover
nmentsett
heof
fi
cialf
ixedexchanger
ate,
for
exampl
e,atKsh80=$1i
nfi
gur
e9.
1,t
hiswoul
dbeabovet
heequi
li
bri
um
exchanger
ate.
 Ther
ewoul
dbeanexcesssuppl
yofdol
lar
sasshownbyhor
izont
aldi
stance
AB.Asar
esul
t,t
her
ewoul
dbedownwar
dpr
essur
eont
heexchanger
atet
o
f
allt
owar
dst
heequi
li
bri
um exchanger
ateofKsh71=$1.t
okeept
he
exchanger
ateati
tsf
ixedl
evelofKsh80=$1,
theKenyangover
nmentwoul
d
havepur
chasedol
lar
swi
thKenyanshi
ll
ingt
ohol
dtheexchanger
ateabove
t
he equi
li
bri
um (
to pr
eventt
he shi
ll
ing appr
eci
ati
ng)by doi
ng t
hist
he
gover
nmentasaddi
ngdol
lar
stoi
tsf
orei
gnexchanger
eser
ves.
 Ont
heot
herhandi
ftheexchanger
atewer
esetbyt
heKenyagover
nmentat
Ksh65=$1i
nfi
gur
e9.
1ther
atewoul
dbebel
owt
heequi
li
bri
um exchange
r
ate.
 Thi
sinducesanexcessdemandf
ordol
lar
sshownbyt
hehor
izont
aldi
stance
CF.t
hiswoul
dcr
eat
eanupwar
dspr
essur
eont
heexchanger
atewhi
chi
flef
t
al
onewoul
dmovet
otheequi
li
bri
um r
ateofKsh71=$1.t
opr
eventt
hist
he
Kenyan gover
nmentwoul
d sel
lthedol
lar
sfr
om i
tsr
eser
veshol
ding of
dol
lar
sint
hemar
kett
ohol
dtheexchanger
atedownati
tsf
ixedl
evel(
to
pr
eventt
heKshf
rom depr
eci
ati
ng)

Def
ini
ti
on:deval
uat
ion:t
hisi
sat
erm usedi
nthef
ixedexchangesyst
em when

97
t
hef
ixedval
ueoft
hecur
rencyi
srevi
sedupwar
ds(
sayt
oKsh85/
$1f
rom Ksh
80/
$1bef
ore)t
hisi
ssynonymoust
odepr
eci
ati
onundert
hef
lexi
bleexchange
r
ate.

Reval
uat
ion:t
hisi
sat
erm usedi
nthef
ixedexchangesyst
em whent
hef
ixed
val
ue oft
he f
orei
gn cur
rency i
nter
ms ofdomest
ic cur
rency i
s adj
ust
ed
downwar
ds(
sayf
rom Ksh80=$1)t
hisi
ssynonymoust
oappr
eci
ati
onunder
t
hef
lexi
bleexchanger
atesyst
em.

THEJ-
CURVEPHENOMENON
 Def
:theJcur
vephenomenoni
sashor
t-
runwor
seni
ngoft
hebal
anceof
t
radebr
oughtaboutbydepr
eci
ati
oni
ntheexchanger
ate.
 Underasyst
em ofaf
lexi
bleexchanger
ate,mar
ketf
orcescor
rectantdef
ici
t
i
nthebal
anceoft
rade.I
nthecasewher
eimpor
tsofacount
ryar
emor
ethan
i
tsexpor
t(bal
anceoft
radedef
ici
t)
,thedomest
iccur
rencywi
lldepr
eci
ate
wi
thr
espectt
ofor
eigncur
rency,maki
ngt
hecount
ri
esexpor
tscheaperand
f
orei
gngoods(
impor
ts)expensi
vef
ordomest
icconsumer
s.
 Thecount
ri
esexpor
tswi
lli
ncr
easei
nthel
ongr
unandi
mpor
tswi
lldecr
ease
andt
hebal
anceoft
radewi
llevent
ual
lybebr
oughtbacki
ntoequi
li
bri
um.
 Thequest
ionhowever
,ishowmucht
imedoesi
ttakef
ort
heequi
li
bri
um t
o
beachi
eved?Whathappensi
ntheshor
trun?
 I
tis bel
i
eved t
hati
nthe shor
trun expor
ts and i
mpor
ts may be l
ess
r
esponsi
vet
ochangesi
nrel
ati
vepr
icesbr
oughtaboutbyachangei
nthe
exchanger
atet
hant
heyar
eint
hel
ongr
un.Thi
simpl
iest
hatt
heshor
trun
el
ast
ici
tyofdemand(
consi
der
abl
emor
eresponsi
ve)
 Thedi
ff
erencebet
weent
heshor
trunandl
ongr
unel
ast
ici
tyofdemandf
or
i
mpor
tsl
eadst
obal
anceoft
radet
oini
ti
all
ywor
senandgr
adual
lyi
mpr
ove
f
oll
owi
ngadepr
eci
ati
onoft
hedomest
iccur
rencywi
thr
espectt
ofor
eign
cur
rency.Thi
sJ-
cur
vephenomenoni
sil
lust
rat
edi
nfi
gur
e9.
2.Thecount
ry
bal
anceoft
radei
sonver
ti
calaxi
sandt
imeont
hehor
izont
alaxi
s.

98
Fi
gur
e9.
2:TheJ-
Cur
vePhenomenon

 Att
imeper
iod ,
thei
nit
ialbal
anceoft
radei
sshownasadef
ici
t(-
)atpoi
ntA.
 I
naf
lexi
bler
atesyst
em,t
hei
nit
ialdef
ici
tleadst
odomest
iccur
rency(
say
Ksh)t
odepr
eci
ateagai
nstt
hef
orei
gncur
rency(
sayt
hedol
lar
)causi
ngt
he
t
radedef
ici
ttoi
ncr
easebet
weent
imeper
iod andt
imeper
iod r
eachi
nga
maxi
mum amountatpoi
ntB.
 Event
ual
lyi
nthel
ongr
unt
het
radedef
ici
tdecr
eases.I
tisel
imi
nat
edwhen
t
imeper
iod i
sreached.Equi
li
bri
um i
nthebal
anceoft
radei
sobt
ainedat

poi
ntF.

EQUI
LIBRI
UM I
NTHEBALANCEOFPAYMENT
THEBPCURVE
 Si
nce we ar
e deal
ing wi
th an open economy,we need t
oint
roduce a
const
ructt
odescr
ibet
hebal
anceofpaymentequi
li
bri
um.

99
 TheBPcur
veshowst
hevar
iouscombi
nat
ionsofi
ncomeandt
hei
nter
est
r
atet
hatpr
oducesequi
li
bri
um i
nthebal
anceofpayment
.
 Equi
li
bri
um i
nthebal
anceofpaymentcanbewr
it
teni
nthef
orm ofan
equat
ion.

eBPi
Wher sbal
anceofpayment
Xi
sexpor
tofgoodsandser
vices
Mi
simpor
tsofgoodsandser
vices
CIi
scapi
tali
nfl
ow
COi
scapi
talout
fl
ow

(
X-M)i
sthecur
rentaccount
.
(
CI-
CO)i
sthecapi
talaccount
.

f(
 I X-
M)i
sasur
plus(
+)oncur
rentaccount
,thent
her
ehast
obeadef
ici
ton
capi
talaccount(
CI-
CO <0)f
orabal
anceofpaymentequi
li
bri
um t
obe
achi
eved.
fBP>0wehavebal
 I anceofpaymentsur
plusot
her
wisewehaveadef
ici
t
(
BP<0)

Der
ivat
ionofBPcur
ve

Let

 Weassumet
hatexpor
tsar
eaut
onomous andt
hati
mpor
tsar
ebot
h

aut
onomousandi
nduced

 Thi
simpl
iest
henetexpor
tbal
ance wi
llt
her
efor
ebesmal
ler
wi
thar
isei
nnat
ionali
ncome.Thi
sisbecausei
mpor
tsar
eani
ncr
easi
ng

100
 f
unct
ionofnat
ional
income(
Y).
 Assumpt
ionmadei
sthatbot
htheexchanger
ateandt
her
ati
oofdomest
ict
o
f
orei
gnpr
icesar
efi
xed.
 Not
ethatchangesi
nexchanger
ate(
e.g.depr
eci
ati
onofdomest
iccur
rency
i
nrel
ati
ont
ofor
eigncur
rencymakesexpor
tscheaperandi
mpor
tsexpensi
ve)
woul
dcauset
heBPcur
vet
oshi
ft
.Si
mil
aref
fect
sar
eexpect
edi
fther
ati
oof
domest
ict
ofor
eignpr
iceschanged.
 Fl
ow ofcapi
tal(
KA)dependsoni
nter
estr
atedi
ff
erent
ialbet
weendomest
ic
andf
orei
gnr
ate.Thati
s

Wher
e i
sdomest
icr
ateofi
nter
est
i
sfor
eignr
ateofi
nter
est
.

 I
f hol
dingofasset
swoul
dshi
ftf
rom f
orei
gni
nter
est payi
ngasset
s
t
o domest
ici
nter
estpayi
ng asset
sin ot
herwor
dscapi
talf
low i
ntot
he
domest
iceconomy.
 I
fweassumet
hatt
hef
orei
gni
nter
estr
atei
sexogenous(
given)
,netcapi
tal
i
nfl
ow KAi
sexpr
essedasani
ncr
easi
ngf
unct
ionofdomest
ici
nter
estr
ate.
Thehi
ghert
hedomest
ici
nter
estr
ate,
thel
argert
henetcapi
tali
nfl
ow.
 Fort
hepur
poseofobt
aini
ngt
heBPcur
ve,
weaskhowt
hei
ncomel
eveland
t
hei
nter
estr
ateaf
fectacount
ry’
sbal
anceofpayment
s.
 Ar
isei
nincomei
nducesmor
eimpor
tsl
eadi
ngt
onetexpor
t t
o
det
eri
orat
ebyt
heamountoft
her
isei
nimpor
ts.
 Thecur
rentaccountdef
ici
t i
sof
fsetbyt
hecapi
talaccountsur
plus

r
esul
ti
ngf
rom ar
isei
nrat
eofi
nter
est t
hatboost
s
capi
tali
nfl
ows.Asar
esul
tequi
li
bri
um i
ntheBOPi
smai
ntai
ned.
 Wet
her
efor
edr
awt
heBPcur
vesassl
opi
ngupwar
dsf
rom l
eftt
ori
ght
.

101
Fi
gur
e9.
3:TheBPCur
ve

 TheBPcur
vesl
opesupwar
dsbecauseahi
gheri
ncomel
eveli
nducesmor
e
i
mpor
tsandwor
senst
hecur
rentaccount
.Ar
isei
nthei
nter
estr
atei
sthen
necessar
yinor
dert
oincr
easecapi
tali
nfl
owswhi
chi
ntur
nmovet
hecapi
tal
accountt
owar
dssur
plusandof
fsett
hewor
seni
ngoft
hecur
rentaccount
.
 Al
ongt
heBPcur
vet
hebal
anceofpaymenti
sinequi
li
bri
um.poi
ntst
othe
l
eftofBP cur
ve(
e.g.poi
ntJ)r
epr
esent
sBOP sur
plus,supposi
ngr
ateof

102
 i
nter
esti
shel
dconst
antat andi
ncomel
eveli
sreducedf
rom t
o .The

f
alli
nthel
evelofnat
ionali
ncomehol
dingiconst
antcausesadecl
inei
n
i
mpor
tsr
elat
ivet
oexpor
tsandgener
ateasur
plus.
 Ont
heot
herhand,poi
ntst
other
ightofBPr
epr
esent
sBOPdef
ici
t.Hol
ding
i
ncomeconst
antat andr
educi
ngt
hei
nter
estr
atef
rom t
o (
poi
ntK)

wor
sens ,
sincecapi
talout
fl
owi
ncr
eases.Thenetef
fectoft
his
i
sthewor
seni
ngofBOP.

SHI
FTI
NTHEBPCURVE
 TheBPcur
vei
nfi
gur
e9.
3ispl
ott
edont
hebasi
sofchangesi
nthei
nter
est
r
ateandi
nthel
evelofnat
ionali
ncome,
hol
dingot
hervar
iabl
esconst
ant
.
 Anappr
eci
ati
on(
depr
eci
ati
on)oft
heexchanger
atewi
llcauset
heBPcur
ve
t
oshi
ftl
eftwar
d(r
ightwar
d)anappr
eci
ati
onofdomest
iccur
rencymakes
i
mpor
tscheaperandexpor
tsexpensi
vewor
seni
ngnetexpor
t(X_
M)
 Thi
scausesBPt
oshi
ftt
othel
eftandupwar
ds,
sinceBOPequi
li
bri
um atany
l
evelofi
nter
est
,ir
equi
resal
owernat
ionali
ncomel
evel
.Theopposi
ter
esul
ts
wi
llbef
oundf
oradepr
eci
ati
onoft
heexchanger
atedepr
eci
ati
onmakesa
count
ry’
sexpor
tlessexpensi
veandi
mpor
tsmor
eexpensi
vei
mpr
ovi
ngnet
expor
ts atever
ylevelofnat
ionali
ncome.

THEEXTENDEDI
S-LM MODEL
 I
nchapt
er4weassumedt
heeconomycl
osedandder
ivedt
heI
Scur
veby
equat
ion

 I
ntheopeneconomycase,wei
ntr
oduceexpor
tsandi
mpor
tsandder
ivet
he
equi
li
bri
um i
nthegoodsmar
ketbyequat
ing

103
 Not
ethati
mpor
tsi
saf
unct
ionofi
ncome
fi
 I easesIi
,decr ncr
easesr
esul
ti
ngt
oinequal
it
yfl
ow (
excessi
nject
ions)
.
Whathappenst
oincomeY?Yi
ncr
easesl
eadi
ngt
oani
ncr
easei
nSand
i
ncr
easei
nM.
 Fort
hedecr nit
easei heext
entt
owhi
chYmustchangei
sdi
ff
erentf
rom t
he
wayi
twoul
dchangei
nacl
osedeconomy(
incl
osedeconomy
onl
y)t
orest
oreequi
li
bri
um.
 Foropeneconomy
, t
orest
oreequi
li
bri
um woul
dbel
it
tl
ebecauseasmal
l
changei
nY i
ncr
easesi
mpor
tsandsavi
ngs.Theef
fect
sonsavi
ngsand
i
mpor
tsdependonMPSandMPM,r
espect
ivel
y.Sot
heI
Sisst
eeperi
nthe
caseofopeneconomyt
hani
nthecl
osedeconomycase.Not
ethati
na
cl
osedeconomyt
oof
fset owi
ngt
o ,i
ncomeYi
ncr
eases,l
endi
ngt
o
onl
yani
ncr
easei
nsavi
ngs.Theext
entof dependsonMPS.Thus
i
ncr
ease i
nincome needed t
orest
ore equi
li
bri
um i
sless i
nthe open
economyt
hani
nthecl
osedeconomycase.

Fi
gur
e9.
4:I
SCur
vei
ntheOpenandCl
osedEconomy

104
 Not
ethatbyopeni
ngt
heeconomyt
heLM cur
ver
emai
nsunaf
fect
ed.
 Not
eal
sot
hatt
heI
Scur
vecanbecausedt
oshi
ftowi
ngt
ofact
orst
hataf
fect
XandM (
apar
tfom iandY)changei
r nint
ernat
ional doesnotshi
ftt
he
I
Scur
ve.

THEBPCURVEANDTHEI
SANDLM CURVESI
NANOPENECONOMY
Fi
gur
e9.
5

105
 Atpoi
nt t
her
eisi
nter
nalequi
li
bri
um aswel
last
hebal
anceof

paymenti
sinequi
li
bri
um (
ext
ernalequi
li
bri
um)

Adef
ici
t(i
.e.ext
ernaldi
sequi
li
bri
um)i
nthebal
anceofpayment
Fi
gur
e9.
6

 I
nthecaseofadef
ici
t,t
heequi
li
bri
um i
nter
estr
ate andequi
li
bri
um l
evelof

nat
ionali
ncome pr
oducedbyt
hei
nter
act
ionoft
heI
SandLM cur
vesf
all

bel
owt
heBPcur
ves.Ati
ncomel
evel ,
thei
nter
estr
ate i
slowert
hant
he

i
nter
estr
atet
hati
srequi
redf
orbal
anceofpaymentt
obei
nequi
li
bri
um as
denot
edbypoi
ntA.

Asur
plusi
nthebal
anceofpayment
Fi
gur
e9.
7

106
 I
nthi
scase,t
heequi
li
bri
um i
nter
estr
ate andt
heequi
li
bri
um l
evelof

nat
ionali
ncome pr
oducedbyt
hei
nter
sect
ionoft
heI
SandLM cur
ve,i
.e

abovet
heBPcur
ve.

ELI
IMI
NATI
ON OFADEFI
CITORSURPLUSI
N THEBOPUNDERDI
FFERENT
ECHANGERATESYSTEMS
 The met
hod bywhi
ch an economygoesaboutel
imi
nat
ing a def
ici
tor
sur
plus i
nthe bal
ance ofpaymentdepends ent
ir
ely on whet
hert
he
i
nter
nat
ionalsyst
em i
soneoff
ixedorf
lexi
bleexchanger
ate.Shi
ft
swi
ll
occuri
nbot
htheI
Scur
veandt
heBPcur
veandpossi
blyi
ntheLM cur
ve,i
n
movi
ngt
oanover
allequi
li
bri
um.

Fi
xedexchanger
ate
 Recal
lthatt
heI
SandLM cur
vesdet
ermi
nef
ir
stt
hei
nter
nalequi
li
bri
um
i
nter
estr
ateandt
hei
nter
nalequi
li
bri
um l
evelofnat
ionali
ncome.Thenand
onl
ythenwi
ll
theBPcur
veshowwhet
herornott
her
eisadef
ici
torasur
plus.

Sol
vingaBOPdef
ici
tunderf
ixedexchanger
ater
egi
me.

107
 Si
ncet
hei
nter
nalequi
li
bri
um f
all
sbel
owt
heBPcur
ve,
ther
eisa

def
ici
tint
hebal
anceofpayment
.
 Thi
sdef
ici
twi
llpr
oduceashor
tageorexcessdemandoff
orei
gncur
rencyi
n
t
hef
orei
gnexchangemar
ket
.Anexcessdemandoff
orei
gncur
rencyi
nthe
f
oregn exchange mar
ketputpr
essur
e on t
he f
orei
gn exchange r
ate
t
o depr
eci
ate(
val
ueofdomest
iccur
rencyt
ofal
l)
.Butt
he
gover
nmentobj
ect
ives undera syst
em off
ixed exchange r
ate ar
eto
mai
ntai
nast
abl
eexchangeval
uebet
weeni
tsdomest
iccur
rencyandf
orei
gn
cur
rency.Topr
eventt
hedomest
iccur
rencyf
rom depr
eci
ati
ng,t
hecent
ral
bankr
eleasesmor
efor
eigncur
rencyf
rom i
tsf
orei
gnexchanger
eser
vesi
n
exchangeoft
heexcessdomest
iccur
rencyi
nthef
orei
gnexchangemar
ket
.
 Bysel
li
ngt
hef
orei
gncur
rencyf
ordomest
icones,
thenomi
nalmoneysuppl
y
hel
dbyt
hepubl
icr
educes.Thi
sisr
epr
esent
edbel
ow byal
eft
war
dshi
ftof
LM cur
vef
rom t
o .Theamountoft
hisshi
ftbyt
heLM cur
vei
s

suf
fi
cientt
oel
imi
nat
ethedef
ici
tint
heBOP.

Fi
gur
e9.
8

108
 Bot
hint
ernalequi
li
bri
um andext
ernalequi
li
bri
um ar
e

achi
evedatt
hehi
gherequi
li
bri
um i
nter
estr
ate andt
hel
owerequi
li
bri
um

l
evelofnat
ionali
ncome .

Sol
vingaBOPsur
plusunderaf
ixedexchanger
ater
egi
me.

109
 Si
ncet
hei
nter
nalequi
li
bri
um f
all
sabovet
heBPcur
ve,
ther
eisa

sur
plusi
nthebal
anceofpayment
.
 Becauseofabal
anceofpaymentsur
plus,t
her
eisexcesssuppl
yoff
orei
gn
cur
rencyi
nthef
orei
gnexchangemar
kett
hatput
spr
essur
eont
hedomest
ic
cur
rencyt
ogai
nval
ueagai
nstt
hef
orei
gncur
rency(
appr
eci
ate)
.Tokeept
he
domest
iccur
rencyf
rom appr
eci
ati
ng,t
hecent
ralbankwi
llpur
chaset
he
excesssuppl
yoff
orei
gncur
rencyi
nthef
orei
gnexchangemar
ket
.Thi
s
pur
chaseoff
orei
gncur
renci
esbyt
hecent
ralbankf
rom t
hepubl
icr
esul
tin
ani
ncr
easei
nthenomi
nalmoneysuppl
y.
 TheLM cur
veshi
ft
sdownwar
dsandt
other
ight
,fr
om t
o wher
e

t
heBPsur
plusi
sel
imi
nat
ed.

Fi
gur
e9.
9

110
 Bot
hint
ernal andext
ernal equi
li
bri
um ar
eachi
evedatt
he

l
owerequi
li
bri
um i
nter
estr
ate andt
hehi
gherequi
li
bri
um l
evelofnat
ional

i
ncome .

Fl
exi
bleexchanger
ater
egi
me
 Underasyst
em off
lexi
blei
nter
estr
ates,ashi
fti
nbot
htheI
Scur
veandt
he
BPcur
veoccur
swi
thchangesi
ntheexchanger
ate.
 I
nthecaseofasur
plusi
nthebal
anceofpayment
,ther
ewi
llbeexcess
suppl
yoff
orei
gncur
rency,whi
chl
eadst
othedepr
eci
ati
onoft
heval
ueof
domest
iccur
rencyr
elat
ivet
ofor
eigncur
rencyasdemonst
rat
edi
nfi
gur
e9.
1

 Expor
tsbecomeexpensi
veandi
mpor
tscheaperadecl
inei
nnetexpor
t(X-
M)
causest
heI
SandBPt
oshi
ftt
othel
eftt
o and (
seef
igur
e9.
10)

111
Fi
gur
e9.
10

Bef
ore Af
ter adj
ust
ment i
n
exchanger
ate

 Theeconomyr
eachesbot
hani
nter
nalandext
ernalequi
li
bri
um at wher
e

t
he cur
ve,t
he cur
veandt
heLM cur
vei
nter
sect
.Theequi
li
bri
um

i
nter
estr
atehasdecl
inedf
rom t
o andt
heequi
li
bri
um l
evelofnat
ional

i
ncomehasf
all
enf
rom t
o .

 Ther
eisnor
easonf
ort
hecent
ralbankt
opur
chaset
heexcesssuppl
yof
f
orei
gncur
renci
esi
nthef
orei
gnexchangemar
ket
,asi
tdi
dunderasyst
em
of f
ixed exchange r
ates. The f
orei
gn exchange mar
ket makes t
he
adj
ust
ment
sint
heexchangeval
uebet
ween t
hedomest
iccur
rencyand
f
orei
gncur
renci
es.

112
Fi
gur
e9.
11:Adj
ust
mentt
oBOPdef
ici
tunderaf
lexi
bleexchanger
ate

 I
nthecaseofadef
ici
tint
hebal
anceofpayment(
seepanelA)t
heKenyan
publ
ichasanexcessdemandf
orf
orei
gncur
rency.Underf
lexi
bleexchange
r
ate,t
her
eisar
isei
nthepr
iceoff
orei
gncur
rencyi
nter
msoft
hedomest
ic
cur
rencyoronot
herwor
dst
hedomest
iccur
rencyl
osesval
uei
nrel
ati
ont
o
f
orei
gncur
rency(
i.
e.depr
eci
ati
oni
ndomest
iccur
rency)
 Expor
ts become cheap and i
mpor
ts expensi
ve,hence r
esul
ti
ng t
othe

113
 i
mpr
ovementi
nnetexpor
tscauset
heI
SandBPcur
vest
oshi
ftout
war
dst
o
t
her
ightt
o and .
 Si
nceaBPequi
li
bri
um r
equi
resahi
gherl
evelofi
nter
estr
atesf
oranyl
evelof
nat
ionali
ncome,
theequi
li
bri
um i
nter
estr
atei
ncr
easesf
rom t
o andt
he

l
evelofnat
ionali
ncomer
isesf
rom t
o .

114