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6.keynesian System

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13 views14 pages

6.keynesian System

Uploaded by

adrianathirah03
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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The Keynesian System:

Money, Interest, and


Income
Interest Rate (r) and AD
⚫ Interest rate affects AD through I
⚫ A higher r reduces I, so AD falls
⚫ Keynes believed that quantity of money
played a key role in determining interest
rate.
⚫ The equilibrium interest rate is the rate
that equates quantity of money
demanded and supplied
⚫ Factors affecting MD and MS affect
interest rate
Keynesian Liquidity Preference
⚫ Liquidity preference refers to the
demand for money, considered as
liquidity.
⚫ The concept was first developed by John
Maynard Keynes in his book The General
Theory of Employment, Interest and
Money (1936) to explain determination of
the interest rate by the supply and
demand for money.
Keynesian Liquidity Preference
❖ LP denotes the functional relation between the
quantity of money demanded and the variables
determining it
❖ Individuals made two decisions: The decision to
save and how to hold their money (in what kind of
assets).
❖ Money may be invested in bonds, t-bills,
commercial paper and others
❖ How liquid these assets are and what is the
preference for being liquid of individuals
(investors) will determine the portfolio distribution
❖ If preference for liquidity is high, demand for
money will increase
Keynesian Money Demand
⚫ Keynes believed the demand for money depended on income
and interest rates.
⚫ Money was held to facilitate normal transactions and as a
precaution for unexpected transactions.
⚫ For both of these motives, money demand depended on
income.
⚫ People also held money as an asset for speculative purposes.
⚫ The speculative motive depends on income and interest
rates.
⚫ People hold more money for speculative purposes when they
expect bond prices to fall, generating a negative return on
bonds.
⚫ Since money demand depends upon expectations about
future interest rates, unstable expectations can make money
demand, and thus velocity, unstable.
Motives of Money Demand
Keynes distinguished three “motives” for holding
money:
1. The “transaction motive”
• People prefer to have liquidity to assure basic
transactions as their income is not constantly
available.
• The amount of liquidity demanded is determined
by the level of income: the higher the income, the
more money demanded for carrying out increased
spending.
• Keynes did not regard transaction balances as
being significantly affected by interest rates.
Motives of Money Demand
2. The “precautionary motive.”
⚫ Balances held instead to provide for contingencies requiring
sudden expenditure and for unforeseen opportunities, such
as unemployment, accident or illness.
⚫ The amount of money demanded for this purpose increases
as income increases.
⚫ Keynes did not appear to regard precautionary balances as
very sensitive to r.
⚫ He lumped together the demand for transaction and for
precautionary reasons as primarily controlled by current
income.
⚫ Thus, M1 = L1 (Y), where the function Ll denotes the demand
for money resulting from the transaction and precautionary
motives.
Motives of Money Demand
3. The “speculative motive”
⚫ balances held in cash rather than invested in bonds, not just
because of the risk that interest rates might rise but rather
because of a definite expectation that the price of long-term
bonds is likely to fall.
⚫ The price of long-term bonds varies inversely with long-term
interest rates.
⚫ People retain liquidity to speculate that bond prices will fall.
⚫ When the interest rate decreases people demand more
money to hold until the interest rate increases, which would
drive down the price of an existing bond.
⚫ Thus, the lower the interest rate, the more money
demanded (and vice versa).
⚫ Keynes denoted speculative demand function as M2=L2 (r)
Cont…
⚫ The sum of the transaction and precautionary
demand and the speculative demand is the total
demand for money, M = M1 + M2 = L1 (Y) + L2 (r).
⚫ The demand for money in the more general form
is M = L(r, Y).
⚫ If you want people to part with liquidity, you must
offer and higher and higher interest rate as
compensation
⚫ inverse relationship between money demand and
the interest rate.
⚫ The money supply is vertical as money is
exogenously supplied by the central bank (i.e. the
money supply is under its complete control).
Money Demand Curve
⚫ Relates
the interest rate and quantity of money
⚫ Downward-sloping
Factors Affecting MD:
1.Price level
r
2.Expected inflation
3.Wealth
4.Payment technology
5.Risk of holding bonds or
money
MD
M
Money Supply Curve
⚫ Relates the interest rate and quantity of money
⚫ MS is assumed to be fixed exogenously by BNM,
so it is vertical.

r MS Factors Affecting MS:


1.Price level
2.Nominal money
supply, M

M
Money Market Equilibrium
⚫ M is the quantity of money, Md is the demand for money
and Ms is the money supply, and r is the real interest rate.
⚫ The equilibrium interest rate (r0) is the rate at which
quantity of money supplied is equal to the quantity of
money demanded.

r
MS

r0
MD

M
LF & LP: Why two theories of
interest rate determination?
Liquidity Preference Loanable Funds

the relationship between interest rate Brings borrowers and savers together,
and money balances is given by determining interest rates by finding
where the demand for money is in where the demand for borrowing = the
equilibrium with the supply of money supply of savings.
set by a central bank. Interest rates can be determined in an
open market, without a central bank.
Changes in Money Market Equilibrium
• An increase in MD increases r
• An increase in MS reduces r

r r
MS0 MS0 MS1

r1
MD1
r0
MD0 MD0
M M

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