Keynesian_02 Ver 3
Transcript of Keynesian_02 Ver 3
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Keynesian System - IIMoney, Interest and income
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C a b Y T ( )
0C a bY bT btY
0( )C a b Y T tY
0Y a bY bT btY I G
C
Y
b bt
a I G bT
1
1
0( )
The Government Spending and Tax Multipliers Algebraically
The Case in Which Tax Revenues Depend on Incomes
Through substitution we get
Solving for Y:
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1
1 b bt
The Government Spending and Tax Multipliers Algebraically
The Case in Which Tax Revenues Depend on Incomes
This means that a $1 increase in Gor I(holding aand T0constant) will
increase the equilibrium level of Yby
Holding a, I, and Gconstant, a fixed or lump-sum tax cut (a cut in T0) will
increase the equilibrium level of income by
btb
b
1
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Money in the Keynesian System
Money affect income via interest rate:
Money Supply increases interest rate decreases aggregatedemand increases national income increases.
Chain1: Money Supply increases interest rate decreases
Chain 2: interest rate decreases aggregate demand increases
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Interest rate and Aggregate demand
Investment demand = f (interest rate).
Investment projects will be pursued only when expected profitability> the cost of the project.
All the components of Investment; business investment, residentialconstruction, consumer durables etc. will respond to the changes ininterest rate.
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Effect of a decrease in the interest rate
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Effect of a decrease in the interest rate
A decline in the interest rate from r0to r1shift the aggregate demandcurve to E1
Interest sensitivity of aggregate demand decides how effective is themonetary policy which works through the interest rate channel.
Interest rate sensitivity of various components of aggregate demandhas to be analyzed.
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Keynesian Theory of interest rate
Chain1: Money Supply increases interest rate decreases.
So, quantity of money plays a key role in the determination ofinterest rate in the economy.
Assumptions: Financial assets includes money and non-money assets (Bonds)
Bonds are perpetuities.
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Determination of Interest rate
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Determination of Interest rate
Interest rate is determined at the point where the supply of money =
demand for money.
Supply of money is determined by the Central bank through variouspolicy tools
Demand for money is determined in the economy due to followingfactors;
Transaction demand
Precautionary demand
Speculative demand
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Demand for Money
Transaction demand for money: Money acts as a medium ofexchange.
Md = f (Yd )
Money is demanded only for transaction purpose only.
Precautionary Motive:
Md = f(Yd)
Money demanded for unexpected events
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Demand for Money
Speculative demand for money:
Md= f(r) , where r is the interest rate.
Money is demanded for speculation; buying and selling bonds orbond transaction.
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Speculative demand for Money
Why people hold money above that needed for transaction andprecautionary motives when bond pay interest rate and money doesnot?
The answer to the above question explained by the motives for
speculative demand for money. It is understood that there is uncertainty of interest rate movement
and this uncertainty of interest rate results the relationship betweeninterest rate and bond price also uncertain.
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Speculative demand for Money
If interest rate are expected to move such a way as to cause capital
losses which outweigh the positive interest earnings on the bond, thenpeople prefer to hold money.
Earning / return on bonds = r expected capital gain/loss
Interest rate and bond prices are inversely related to each other.
Interest rate bond price
Interest rate bond price
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Speculative demand for Money
Suppose one Rs. 1000 bond pays the holder Rs.50 per year as coupon. (r= 5%)
How much would this bond be worth today?
This depends on the current market interest rate.
If current market interest rate rc= 5%, the bond sold at Rs.1000. (bond
price)
If current market interest rate rc= 10%, the bond sold at Rs.500 (50/500= 0.10 (10%))
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Speculative demand for Money
Hence, when the interest rate increases from 5% to 10%, bonds will besold at a capital loss of 500.
If interest rate decreases to 2%, bond price will be 2,500.
Thus a decline in the interest rate result in a capital gain of existing
bonds.
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Speculative demand for Money
Return on money = 0
Expected return on bonds = r + expected capital gain.
Expected return on bonds = r - expected capital loss.
Hence, expectations about future interest rate movement is crucial.
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Expectation about interest rate andspeculative demand for money
Every investor has a conception of normal interest rate (rn).
When rc> rn investor expect the interest rate to fall.
When rc< rn investor expect the interest rate to increase.
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Concept of Normal interest rate.
Every individual has a concept of normal interest rate in their mind. ith individual has rni as the normal interest rate.
If the current interest rate above rni,you expect the interest rate to fall tonormal.
When you expect the interest rate to fall, you will have capital gain if you
are holding bonds.
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Concept of Normal interest rate.
Hence, you prefer to hold bonds between the range (rni to )
When the current interest rate is below the normal rate, the investorexpect it to increase to the normal.
Hence, they will experience a capital loss of holding bonds.
Hence, they will hold money between the range (0 to rni ).
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Speculative Demand Keynes assumes that different people have different views on the
normal interest rate The curve is flattens out at a very low interest rate, reflecting at a lower
rate there is a general expectation of capital loss on bond that outweighspositive interest earnings.
At this rate, increment to wealth would be held in the form of money.
No further drops in the interest rate is required to attract speculativedemand for money.
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The IS-LM modelEquilibrium in the goods and money markets
Understanding public policy
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The IS-LM model
The IS-LM model translates the General Theoryof Keynes into neoclassical terms (often calledthe neoclassic synthesis)
It was proposed by John Hicks in 1937 in a papercalled Mr Keynes and the "Classics": ASuggested Interpretation and enhanced by AlvinHansen (hence it is also called the Hicks-
Hansen model).
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The IS-LM model
The model examines the combined equilibriumof two markets :
The goods market, which is at equilibrium when investments equalsavings, hence IS.
The money market, which is at equilibrium when the demand forliquidity equals money supply, hence LM.
Examining the joint equilibrium in these two markets allows us todetermine two variables : output Yand the interest rate i.
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The IS-LM model
The model rests on two fundamental assumptions All prices (including wages) are fixed.
There exists excess production capacity in the economy
This is a complete change in perspective comparedto classical economics:
The level of demand determines the level of output and employment.
There can be an equilibrium level of involuntary unemployment.
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The IS-LM modelThe IS-LMmodel has become the standard
modelin macroeconomics.
Its essential contribution (linked to that of Keynes)
is this potential equilibrium unemployment: Such a situation is impossible in earlier neoclassic models, as the price of
labour (like all prices) is assumed to adjust naturally until supply and
demand for labour are balanced.
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This is whyIS-LM remains central to modern
macroeconomics, and has been extended to
explain more markets/ variables:
TheAS-AD (Aggregate Supply-Aggregate Demand) model adds inflation
into the problem
The Mundell-Flemingmodel deals with international trade adds Balance of
Payment into the problem.
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The IS-LM model
The IS curve
The LM curve
Macroeconomic equilibrium and policy
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The IS curve
The IS curve shows all the combinations of interestrates iand outputs Yfor which the goods market is inequilibrium
It is based on the goods market equilibrium we have examined in the KeynesianSystemI (chap.5)
However, a simplifying assumption we made initiallywas that investment Iwas exogenous
We know that investment actually depends negatively on the level of interest
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The IS curve
The Investment function
Is the sum of private investment (endogenous) and publicinvestment (exogenous)
Here, the interest rate has a real interpretation: it is themarginal profitability of investment
Ig
i
gI I i G T
Ig= I(i) + (G-T)
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The IS curve
The Savings function Is obtained from the aggregate demand equation,
subtracting investment and consumption:S=Y-C-T
S= -C0+(1-b)(Y-T)
S
Y
S = -C0+ (1 - b)(Y-T)
mps: 0< 1-b)
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The IS curve
i
i i
Y
Ig
S
i Y
45IS
S = -C0+ (1 - b)(Y-T)
Ig= I(i) + (G-T)
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IS Curve
IS curve is the locus of all the points representing equilibrium in thegoods/ commodity market.
It shows various combinations of I and Y where goods marketequilibrium is attained.
The IS curve slopes downwards as at lower interest rate, the level of
investment is high. For equilibrium, Income has to be higher to induce higher saving to be
equal to higher investments.
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Factors that determine the Slope of theIS schedule.
(a) If the investment function is inelastic, a given change in i, resultsa small change in investment, which requires a small change insaving. Given the saving function, it requires a small change inincome (Y). Hence the IS curve is steeper.
If the investment function is elastic, the IS curve is Flatter.
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Factors that determine the Slope of theIS schedule.
(b)Higher is the marginal propensity to save (MPS), IS curve will besteeper.
Lower is the marginal propensity to save (MPS), IS curve will be Flatter.
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The IS curve
i
i i
Y
Ig
S
i Y
45IS
Higher propensity
to consume
IS flattens out
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Factors that explains the Shift in the ISSchedule
IS curve will shift when any or all autonomous expenditures changes(G, T and I)
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The IS curve
i
i i
Y
Ig S
i Y
45IS
Reduction inpublic spending
IS shifts to theleft
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Changes in the Govt. Expenditures andimpact on the IS Schedule
Before changes in the G, the equilibrium was
I + G = S + T
Now, I + G1= S1+ T
So, G = S
S = (1b) Y
Or Y = 1/ (1-b) G at initial rate of interest. (i)
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Changes in Tax and impact on the ISSchedule
Tax increases, saving decreases by (1-b) MPS
Hence product market equilibrium is;
I + G = S1+ T1
As I and G are unchanged, S1 and T1are such that S = T or S + T =
0
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Changes in Tax and impact on the ISSchedule
S = (1b) (YT)
= (1b) Y(1b) T
As S + T = 0;
(1b)
Y(1b)
T +
T = 0 (1b) Y + b T = 0
(1b) Y = - b T
Y = (- b) /(1b) T
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IS Schedule
(1) IS curve slopes downward to the right
(2) IS will be relatively flat if interest elasticity of investment is highand MPC is high.
(3) IS will shift to the right by (1/1-b)when govt. expenditure will
increase
(4) IS will shift to the left byb / (1-b) when tax increases.
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The IS-LM model
The IS curve
The LM curve
Macroeconomic equilibrium and policy
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The LM curve
The LM curve shows all the combinations of interestrates iand outputs Yfor which the money market isin equilibrium
It is based on the money market equilibrium we haveexamined last two weeks
This time the interest rate ihas a monetary
interpretation: It is the opportunity cost of money, in other words thepayment made for renouncing liquidity (preference forliquidity)
The LM curve
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The LM curve
Liquidity preference: Given a level of output Y, the level of
interest iadjusts so that the demand for money (given by the
liquidity function L) equals the exogenous supply:
M = Money supple (exogenous)
P = Level of prices (exogenous by assumption)
iYLP
M,
The LM curve
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The LM curve
Simplifying assumption: The liquidity function, which gives the demand forreal money balances, can be decomposed depending on the type ofdemand
There are two motives for demanding real money balances:
The transaction and precautionary motiveL1(Y): The money demanded inorder to be able to transact in the future (function of the level of output)
The speculation motive L2(i): The money demanded for purposes of
speculation (opportunity cost of the interest rate). When interest is high,people dont want to hold money, whereas when the rates are low, moneydemanded increases.
iLYLiYL 21,
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The LM curve
L1(Y)
Real Money Balances demanded for
the transaction and precautionarymotive (L1) are an increasing function
of output Y
Y
L1(Y)
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The LM curve
i
Real Money Balances demanded for thespeculation motive (L2)are a decreasing
function of the rate of interest.
Under a given (low) level of interest, the
money demanded becomes infinite: agents do
not want to hold assets, and any money
available is hoarded.
Liquidity Trap
L2(i)
L2(i)
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The LM curve
L1Money supply M is fixed and exgogenous. The moneymarket equilibrium requires that the sum of money
demands add up to the supply of money
(M/P) = L1(Y) + L2(i)
L2
Given one demand for money, say L2(i), then the
other is given, by:
L1(Y) = (M/P) - L2(i)
(M/P) = L1(Y) + L2(i)
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The LM curvei i
Y
Y
L1(Y) L1(Y)
L2(Y)
L2(Y)
LM
45
L1(Y)
L2(i)
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LM curve is the locus of points representing equilibrium in the moneymarket.
Money market equilibrium means money demand should be equal tomoney supply.
The LM curve slopes upward because as the interest rate increases, thespeculative demand for money decreases.
Given the supply of money the money demand for transaction andprecautionary should increase.
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Money demand for that will increase if income increases.
Hence, the points of equilibrium in the money market consistent withincreasing interest rate and increasing income.
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Factor that determine the slope of the LMcurve.
Steeper money demand schedule reflect the interest elasticity of moneydemand is low, hence, LM curve will be steep
Flat money demand schedule reflect the interest elasticity will be high,hence LM curve will be flat.
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Shift in the LM curve
Change in the money supply
Change in the money demand.
LM will shift downward (upward) to right (left) with increase(decrease) in money supply.
LM will shift upward (downward) to the left with increase (decrease)in money demand at given level of income and interest rate.
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The LM curvei i
Y
Y
L1(Y) L1(Y)
L2(Y)
L2(Y)
LM
LM
4545
Fall in money
supply
Pushes LM left
L1(Y)
L2(i)
LM
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LM curve
LM schedule giving the combinations of Y and r that represent moneymarket equilibrium
LM curve slopes upward
LM will be relatively flat if interest elasticity of money demand is veryhigh.
LM will shift downward (upward) to right (left) with increase (decrease)
in money supply. LM will shift upward (downward) to the left with increase (decrease) in
money demand at given level of income and interest rate.
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The IS-LM model
The IS curve
The LM curve
Macroeconomic equilibrium and policy
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IS
LM
Macroeconomic equilibrium and policy
Income, Output Y
Interestrate
i
Y*
i*
The intersection of IS and LM
represents the simultaneous
equilibrium on the goods and
the money market
For a given value ofgovernment spending G, taxes
T, money supply M and prices
P
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Macroeconomic equilibrium and policy
IS-LM can be used to assess the impact ofexogenous shocks on the endogenous variables ofthe model (interest rates and output)
One can also evaluate the effectiveness of thepolicy mix, i.e. the combination of: Fiscal policy: changes to government spending and taxes
Monetary policy: changes to money supply
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Macroeconomic equilibrium and policy
Fiscal policy affects the equilibrium in the goodsmarket, viachanges in G and T. Weve seen that this influences the IS curve.
The shift in IS affects both endogenous variables(output and interest rate) In the previous chapter, we assumed that investment was
exogenous (There was no interest rate in the basic model)
Idid not change when Gor Twere changed
This is no longer the case with IS-LM : there is a crowdingout effect
Macroeconomic equilibrium and policy
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q p y
1. An increase in spending G pushes IS tothe right
The difference between Ykand YIS-LM is
the crowding out effect
2. By an amount:G
c
1
1
IS
LM
Y1
i1
Income, Output Y
Interestrate
i
i2
YIS-LM YK
But as Y increases (multiplier effect), so
does money demand. The interest rate
must increase to compensate, which
discourages investment
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