Keynesian System - II
Money, Interest and income
Money in the Keynesian System
• Money affect income via interest rate:
• Money Supply increases  interest rate
decreases  aggregate demand increases 
national income increases.
• Chain – 1: Money Supply increases  interest
rate decreases
• Chain 2: interest rate decreases  aggregate
demand increases
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, residential construction,
consumer durables etc. will respond to the
changes in interest rate.
Effect of a decrease in the interest rate
Effect of a decrease in the interest rate
• A decline in the interest rate from r0 to r1 shift
the aggregate demand curve to E1
• Interest sensitivity of aggregate demand
decides how effective is the monetary policy
which works through the interest rate
channel.
• Interest rate sensitivity of various components
of aggregate demand has to be analyzed.
Keynesian Theory of interest rate
• Chain – 1: Money Supply increases  interest
rate decreases.
• So, quantity of money plays a key role in the
determination of interest rate in the economy.
• Assumptions:
– Financial assets includes money and non-money
assets (Bonds)
– Bonds are perpetuities.
Determination of Interest rate
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 various policy tools
• Demand for money is determined in the
economy due to following factors;
– Transaction demand
– Precautionary demand
– Speculative demand
Demand for Money
• Transaction demand for money: Money acts
as a medium of exchange.
• Md = f (Yd )
• Money is demanded only for transaction
purpose only.
• Precautionary Motive:
• Md = f(Yd )
• Money demanded for unexpected events
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 or bond transaction.
Speculative demand for Money
• Why people hold money above that needed for
transaction and precautionary motives when
bond pay interest rate and money does not?
• 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 between
interest rate and bond price also uncertain.
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,
then people 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
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%))
Speculative demand for Money
• Hence, when the interest rate increases from
5% to 10%, bonds will be sold 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.
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.
Expectation about interest rate and
speculative 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.
•
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 to normal.
• When you expect the interest rate to fall, you
will have capital gain if you are holding bonds.
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 investor expect 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 ).
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
outweighs positive 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 speculative demand for money.
Concept of Liquidity Trap
A liquidity trap is a
situation, described in
Keynesian Economics, in
which injections of cash
into the private banking
system by a central bank
fail to decrease interest
rates and hence make
monetary policy
ineffective.
The IS-LM model
Equilibrium in the goods and money markets
Understanding public policy
The IS-LM model
• The IS-LM model translates the General Theory
of Keynes into neoclassical terms (often called
the neoclassical synthesis )
• It was proposed by John Hicks in 1937 in a
paper called “Mr Keynes and the "Classics": A
Suggested Interpretation” and enhanced by
Alvin Hansen (hence it is also called the HicksHansen model).
The IS-LM model
• The model examines the combined equilibrium
of two markets :
– The goods market, which is at equilibrium
when investments (I) equal savings (S),
hence IS.
– The money market, which is at equilibrium
when the demand for liquidity (L) equals
money (M) supply, hence LM.
– Examining the joint equilibrium in these two
markets allows us to determine two variables :
output (Y) and the interest rate (r).
The IS-LM model
• The IS-LM model has become the “standard
model” in macroeconomics and remains central to
modern macroeconomics, and has been extended
to explain more markets/ variables:
– The AS-AD (Aggregate Supply-Aggregate
Demand) model adds inflation into the problem
– The Mundell-Fleming model deals with
international trade adds Balance of Payment into
the problem.
The IS-LM model
The IS curve
The LM curve
Macroeconomic equilibrium and policy
The IS curve
• The IS curve shows all the combinations of interest
rates (r) and outputs (Y) for which the goods market
is in equilibrium
– It is based on the goods market equilibrium we
have examined in the Keynesian System – I
(chap.5)
• However, a simplifying assumption we made initially
was that investment I was exogenous
– We know that investment actually depends
negatively on the level of interest
The IS curve
• The Investment function
– Is the sum of private investment (endogenous) and public
investment (exogenous)
I g  I  i   G  T 

– Here, the interest rate has a real interpretation: it is the
marginal profitability of investment
Ig
Ig = I(i) + (G-T)
i
Y
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
S = -C0 + (1 - b)(Y-T)
mps: 0< (1-b) <1
Y
IS Curve
• IS curve is the locus of all the points representing
equilibrium in the goods/ commodity market.
• It shows various combinations of I and Y where
goods market equilibrium 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.
IS and LM
LM Curve
• The LM curve shows all the combinations of
interest rates i and outputs Y for which the
money market is in equilibrium
• If interest rate increases, Y should increase so
that money demand = money supply.
• As r increases, the speculative demand for money
decreases, hence transaction demand for money
has increase which requires Y should increase.
• And LM curve is upward sloping.