Money, Interest and income 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.

Equilibrium in the goods and money markets Understanding public policy 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 Hicks-Hansen 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.

Macroeconomic equilibrium and policy 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) 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.