The Quantity Theory and the Keynesian Theory of Money

Classical analysis of prices and inflation This model gives an introduction to equilibrium in the money market It further highlights important theoretical controversies between different schools of thought in economics Keynesians Monetarists

Milton Friedman

The quantity theory is by definition correct MV = PY M = money supply V = velocity of circulation P = price level Y = national income

Money and the price level Since MV = PY, it must be that P = MV/Y Y is given like Yf (flexible prices), V is constant. Therefore, Change in M = change in P ”Inflation is anywhere and everywhere a monetary phenomenon”

The effect of printing extra money: the classical analysis AD2 AD1 AS Price level P2 P1 O Q1 National output

Money and prices in Norway 1900-2000

Money and Interest Rates The Demand for Money

Keynesian money demand Why do we need money: Transaction purposes Precautionary purposes Safety purposes Money demand is above all dependent on: income (+) interest rates (-)

THE DEMAND FOR MONEY The motives for holding money: liquidity preference transactions and precautionary demand for money: L1 9

The transactions-plus-precautionary demand for money: L1 Rate of interest O Active balances

THE DEMAND FOR MONEY The motives for holding money: liquidity preference transactions and precautionary demand for money: L1 speculative demand for money: L2 9

The speculative demand for money: L2 Rate of interest O Idle balances

THE DEMAND FOR MONEY The motives for holding money: liquidity preference transactions and precautionary demand for money: L1 speculative demand for money: L2 the total demand for money: L1 + L2 9

The total demand-for-money curve: L (= L1 + L2) Rate of interest L1 O Total money balances

Money and Interest Rates Equilibrium in the Money Market

The supply of money curve: (a) exogenous money supply MS Rate of interest O Quantity of money

Equilibrium in the money market MS Rate of interest re O Me Money

Equilibrium in the money market MS Rate of interest re O Me Money

Relationship between the Money and Goods Markets

Relationship between the Money and Goods Markets Effects of Monetary Changes on National Income

Effect of a rise in money supply: the traditional Keynesian transmission mechanism MS r1 r1 Rate of interest Rate of interest I1 L O O Money Investment

Effect of a rise in money supply: the traditional Keynesian transmission mechanism MS MS' r1 r1 Rate of interest Rate of interest r2 I2 L I O I1 O Money Investment (a) Stage 1: MS­ ® r ¯ (b) Stage 2: r ¯ ® I ­

Different views on the demand for investment Rate of interest Rate of interest r1 r1 I I O I1 O I1 Investment Investment (a) Keynesian (b) New classical / Monetarist

Different views on the demand for investment Rate of interest Rate of interest I2 r1 r1 I I O I1 O I1 Investment Investment (a) Keynesian (b) New classical / Monetarist

Different views on the demand for investment Rate of interest Rate of interest I2 r1 r1 I I O I2 I1 O I1 Investment Investment (a) Keynesian (b) New classical / Monetarist

Relationship between the Money and Goods Markets ISLM Analysis

Sir John Hicks (1904 – 1989)

Goods market equilibrium: deriving the IS curve Assume that an interest rate of r1 gives investment of I1 and saving of S1 Injections, Withdrawals I1 O r1 Rate of interest O

Goods market equilibrium: deriving the IS curve Assume that an interest rate of r1 gives investment of I1 and saving of S1 Injections, Withdrawals S1 I1 Y1 O r1 Rate of interest O

Goods market equilibrium: deriving the IS curve Assume that an interest rate of r1 gives investment of I1 and saving of S1 Injections, Withdrawals S1 I1 O Y1 r1 Rate of interest O Y1

Goods market equilibrium: deriving the IS curve Assume that an interest rate of r1 gives investment of I1 and saving of S1 Injections, Withdrawals S1 I1 O Y1 a r1 Rate of interest O Y1

Goods market equilibrium: deriving the IS curve Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2 Injections, Withdrawals S1 I2 Y2 I1 O Y1 a r1 Rate of interest r2 O Y1

Goods market equilibrium: deriving the IS curve Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2 Injections, Withdrawals S1 S2 I2 I1 O Y1 Y2 a r1 Rate of interest r2 O Y1

Goods market equilibrium: deriving the IS curve Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2 Injections, Withdrawals S1 S2 I2 I1 O Y1 Y2 a r1 Rate of interest b r2 O Y1

Goods market equilibrium: deriving the IS curve Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2 Injections, Withdrawals S1 S2 I2 I1 O Y1 Y2 a r1 Rate of interest b r2 IS O Y1

The IS curve a b Injections, Withdrawals S1 S2 I2 I1 O Y1 Y2 Rate of interest b r2 IS O Y1

Money market equilibrium: deriving the LM curve Assume that at a level of national income, Y1, the demand for money is L' L' Rate of interest Rate of interest O O Y1 Money National income

Money market equilibrium: deriving the LM curve Assume that at a level of national income, Y1, the demand for money is L' MS Rate of interest Rate of interest L' O O Y1 Money National income

Money market equilibrium: deriving the LM curve Assume that at a level of national income, Y1, the demand for money is L' MS Rate of interest Rate of interest r1 r1 L' O O Y1 Money National income

Money market equilibrium: deriving the LM curve Assume that at a level of national income, Y1, the demand for money is L' MS Rate of interest Rate of interest c r1 r1 L' O O Y1 Money National income

Money market equilibrium: deriving the LM curve Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS Rate of interest Rate of interest c r1 r1 L' O O Y1 Y2 Money National income

Money market equilibrium: deriving the LM curve Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS r2 r2 Rate of interest Rate of interest c r1 r1 L" L' O O Y1 Y2 Money National income

Money market equilibrium: deriving the LM curve Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS d r2 r2 Rate of interest Rate of interest c r1 r1 L" L' O O Y1 Y2 Money National income

Money market equilibrium: deriving the LM curve Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS LM d r2 r2 Rate of interest Rate of interest c r1 r1 L" L' O O Y1 Y2 Money National income

Equilibrium in both the goods and money markets LM IS Rate of interest O National income

Equilibrium in both the goods and money markets LM Assume that national income is currently at a level of Y1 Rate of interest a Y1 IS O National income

Equilibrium in both the goods and money markets LM This gives a rate of interest of r1 (point a) Rate of interest a r1 IS O Y1 National income

Equilibrium in both the goods and money markets LM But at r1, national income is below the goods market equilibrium level (Y2) Rate of interest a b r1 Y2 IS O Y1 National income

Equilibrium in both the goods and money markets But as income rises, so there will be a movement up the LM curve. The interest rate will rise, thereby reducing national income below Y2. LM Rate of interest a b r1 IS O Y1 Y2 National income

Equilibrium in both the goods and money markets LM Rate of interest re Ye IS O National income

ISLM analysis of changes in the goods and money markets Rate of interest r1 IS O Y1 National income

ISLM analysis of changes in the goods and money markets A rise in injections Rate of interest r2 Y2 r1 IS1 O Y1 National income

ISLM analysis of changes in the goods and money markets A rise in the money supply Rate of interest r1 r3 Y3 IS O Y1 National income

ISLM analysis of changes in the goods and money markets A rise in both injections and money supply Rate of interest r1 Y4 IS1 O Y1 National income

Liquidity trap IS` R IS LM Y

The classical case R IS` IS LM Y