 The money supply (MS) is assumed to be an autonomous variable-- that is, MS is under the control of the FED. Interest rate (r) Money supply (MS) MSMS’ MS  MS’ due to: Open market purchase by the FED. Decrease in rr. Decrease in the discount rate

3The Keynesian demand for money (D M ) (or “liquidity preference”) function can be expressed by : 3D M = f (r, Y), where:  D M /  r < 0  demand for money is inversely related to the interest rate, ceteris paribus.  D M /  Y > 0  demand for money is positively relation to real income (GDP), ceteris paribus. Demand for Money (D M ) in the Keynesian System

r DMDM D1MD1M D2MD2M       due to: Decrease in r, ceteris paribus    due to: increase in Y, ceteris paribus. Market bearishness A change in the demand for money (D M )

r M D, MS 120 MS DMDM 8  The equilibrium interest rate satisfies the condition: D M = MS

 The term “monetary transmission mechanism” means the channels through which changes in monetary policy (or the money supply) are “transmitted” to important macroecomic variables such as real GDP, employment, and prices. In Keynesian theory, monetary policy is transmitted to aggregate demand via the interest rate-investment linkage Keynesian view of the transmission mechanism

r MS, D M r I MS MS’ DMDM AE Y 2,1002,175 AE = Y AE 1 AE 2 Expansionary monetary policy: The Keynesian interpretation

r I I2I2 I1I Not interest-sensitive The FED may be successful in decreasing interest rates. But what if investment spending fails to respond? Why monetary policy may be ineffective

MS MS’ 3 D M, MS r At an interest rate of 3% or below, wealth holders prefer money to bonds, equities, etc. Hence D M is horizontal at an interest rate of 3 %  MS leaves r unchanged; hence, no effect on I, Y, or employment. DMDM Why monetary policy may be ineffective, part 2

The FED’s contractionary regime has been ineffective so far 0 A B MS ’ MS rr I 0 DMDM I1I1 I2I2

Effect of rising mortgage interest rates on monthly mortgage payments Amount Borrowed TermInterest Rate Monthly Payment $100,00030 years7.5%$ ,00030 years8.25%$751.27