Keynesian IS-LM The Keynesian System (II): Money, Inteest, and Income
Poblems with the Income-Expenditue Model What about pices? Don t they change when AS and AD conditions change? Don t they have an influence? Ae fims eally indiffeent to changes in the eal wage ate? These issues emain to be addessed... 2
Money in the Keynesian Model Recall the classical model: Tansactions motive: people hold money only to make tansactions Rejects the stoe of value theoy of the mecantilists, aguing that: Money beas no inteest, and A ational peson would not foego a positive etun by holding money unless he/she planned to make a tansaction. People do not hoad money. 3
Liquidity Pefeence Theoy Money is: 1. A Medium of Exchange 2. A Stoe of Value 3. A Unit of Account The fist two ceate demands fo money. 4
Liquidity Pefeence Theoy Tansactions Motive yields tansactions demand fo money Stoe of Value yields: Pecautionay Motive yielding pecautionay demand fo money Speculative Motive yielding the speculative demand fo money Thee ae easons why someone might ationally hoad money! 5
Speculative Demand (1) Keynes consides a potfolio of financial assets. All financial assets can be consideed as money o bonds: Money (M): yields no etun Bonds (B): yield a etun Wh = M + B 6
Speculative Demand (2) Example Pepetuity (a bond that neve matues): Bond is issued at $1 Coupon ate is $5 5/1=5% Late, maket inteest double to 1% How much can you sell the bond fo? Ans: $5 because 5/5=1% When inteest ates ise, bond pices fall capital losses! 7
Speculative Demand (3) M d M People decide to hold money instead of bonds when inteest ates get so low that they cannot possibly go lowe. The move to money to avoid capital losses. Thee is a ational motive fo hoading money!!! L p =L p () (-) As inteest ates fall, B d and M d. 8
Pecautionay Demand People hold money ( pecautionay balances ) fo unfoeseeable expenses. These holdings ( balances ) tend to: Rise with income, and Fall with inteest ates. L p = L p (Y,) (+) (-) 9
Ambiguity in the Money Maket In the classical model: M s = M (exogenous) M d = M d (Y) We used these elationships to ceate the AD cuve. In Keynes model: M s = M (exogenous) M d = L(Y,) M s = M d M = L(Y,) is the money maket outcome. 1
Sidenote: : Hicks Little Appaatus Si John Hicks, 1939, M Keynes and the Classics, a Suggested Intepetation Intoduces the IS-LM Model as a way of making sense of Keynes Geneal Theoy. 11
Keynesian Money Maket M = L(Y,) is the equilibium in the money maket. Thee is not one single vaiable that can change to clea the maket. Thee ae two! The money maket cannot tell us alone what the supply and demand fo money will be. Money is not dichotomous. 12
Hicks Intepetation: LM Cuve LM LM Cuve (L=M): all those combinations of eal inteest ates and income which bing the money supply equal to money demand. Y 13
LM Cuve Slopes Upwad Because... Assumes M s = M (exogenous) If Y inceases, tansactions and pecautionay demand incease. Thee will be excess demand in the money makets Inteest ates will be diven upwad So Y, and the LM Cuve slopes upwad. 1 M s M d (Y 1 ) M d (Y ) M 14
LM Cuve Slopes Upwad Because... Liquidity Pefeence is: L = L(Y,) Money Supply is: M s = M = M M s = M d implies M = L(Y,) LM Cuve Diffeentiating: d dy = L Y L ( + ) = > ( ) 15
LM and the Money Maket M s LM M d (Y 2 ) 1 M d (Y 1 ) M d (Y ) M Y Y 1 Y 2 Y 16
Changes in Money Supply M s M s M s M s M s * M d M 17
Capital Maket Investment I = I(,E) = I() But Saving S = S(Y) o S(Yd) So thee is not a single pice vaiable to clea the capital maket! I() = S(Y) IS Cuve: IS = IS(Y,) IS: all those combinations of Y and which make the capital maket clea. Equivalently, IS is all those combinations of Y and fo which supply = demand in the loanable funds maket. Thus the eal secto cannot be esolved without consideing money maket outcomes. Money is NOT dichotomous. 18
IS Cuve Slopes downwad because I Y IS Y 19
IS Cuve Slopes Downwad Because... Recall that: I + T = S + G o I() + T = S(Y) + G Diffeentiate implicitly with espect to Y and : d dy = ds dy di d = ( + ) ( ) < 2
S S I = S 2 1 I 1 = S 1 I I 2 = S 2 I 2 I 1 I I Y 2 Y 1 Y Y 2 1 IS Y 2 Y 1 Y Y 21
Money and Investment * M s M d M* M I* The eal and monetay sectos ae linked. Money mattes! I The inteest ate is detemined in the money maket. Decision makes in fims compae this ate to the MEC and make the decision egading investment. I 22
IS-LM LM Note that the eal and monetay sectos of the economy ae esolved togethe. * Y* IS Y Money mattes to eal secto outcomes. Thee is no dichotomy. 23
Money-Income Tansmission The Keynes Effect (Money Income Tansmission Mechanism): M s B d P B C I duables AD P Money is not neutal (in the shot un), and thee is no dichotomy. Some moden Keynesians ague fo long-un neutality, but shot-un nonneutality. Changes in the money supply affect the eal secto though the inteest ate channel. 24
Notes on IS-LM LM is a stock equilibium (beginning of peiod. IS is a flow equilibium (end of peiod). The equilibium is an equilibium of flows constained by stocks. It is a cash-flow equilibium. The time fame is long enough fo full adjustment of eal income and inteest, shot enough so stocks do not change. IS-LM equilibium is not pemanent. S> implies that wealth (allocations) ae inceasing ove time. Theefoe LM is shifting due to the stock of bonds. If net investment is positive, then the capital stock gows. 25
26 Lineaized Lineaized IS IS-LM LM Y k P M ky P M ky P M LM β β β β + = = = : Y c ct S G I Y c ct G I S T ct T Y c G I S T T Y c S G I T Y c S S I I T S G I IS α α α α α α + + = + + = + + + = + + = + + = = + = + 1 ) ( ) (1 ) ( ) (1 ) ( ) )( (1 ) )( (1 :
Lineaized IS-LM I + G S ct α * k β LM ( 1 c) α IS M Pβ Y* Y 27
Classical Model? (β=)( LM I + G S ct α * ( 1 c) α IS Y* Y 28