1 Quantity Theory of Money Velocity P  Y V = M Equation of Exchange M  V = P  Y Quantity Theory of Money 1. Irving Fisher’s view: V is fairly constant 2. Equation of exchange no longer identity 3. Nominal income, PY, determined by M 4. Classicals assume Y is determined by real factors, not monetary 5. P determined by M Quantity Theory of Money Demand 1 M =  PY V M d = k  PY Implication: interest rates not important to M d

Change in Velocity from Year to Year: 1915–2002

Cambridge Approach Is velocity constant? 1.Classicals thought V constant because didn’t have good data 2.After Great Depression, economists realized velocity far from constant

Keynes’s Liquidity Preference Theory 3 Motives 1.Transactions motive—related to Y 2.Precautionary motive—constant 3.Speculative motive A. related to W and Y B. negatively related to i Liquidity Preference M d M d = f(i, Y) = f(i, Y) P – + P – +

Keynes’s Liquidity Preference Theory Implication: Velocity not constant P 1 P 1 = M d f(i,Y) M d f(i,Y) Multiply both sides by Y and substitute in M = M d PY Y PY Y V = = M f(i,Y) M f(i,Y) 1. i , f(i,Y) , V  2. Change in expectations of future i or change f(i,Y) results in a change in V

6 Determination of Output Keynesian IS-LM Model assumes price level is fixed Aggregate Demand Y ad = C + I + G + NX Equilibrium Y = Y ad Consumption Function C = a + (mpc  Y D ) Investment 1.Fixed investment 2.Inventory investment Only planned investment is included in Y ad

7 Consumption Function

8 Keynesian Cross Diagram Assume G = 0, NX = 0, T = 0 Y ad = C + I = Y = Y Equilibrium: 1.When Y > Y *, I u > 0  Y  to Y* 2.When Y < Y *, I u < 0  Y  to Y*

Expenditure Multiplier

Analysis of Figure 3: Expenditure Multiplier  I =   Y/  I = 200/100 = 2 1 Y = (a + I)   1 – mpc A = a + I = autonomous spending Conclusions: 1.Expenditure multiplier =  Y/  A = 1/(1 – mpc) whether change in A is due to change in a or I 2.Animal spirits change A

The Great Depression and the Collapse of Investment

Role of Government

Analysis of Figure 5: Role of Government  G = + 400,  T = With no G and T, Y d = C + I = mpc  Y = Y, Y 1 = With G, Y= C + I + G = Y, Y 2 = With G and T, Y d = mpc  Y – mpc  T = Y, Y 3 = 1400 Conclusions: 1.G  Y  ; T  Y  2.  G =  T = + 400, Y  400

Role of International Trade  NX = +100,  Y/  NX= 200/100 = 2 = 1/(1 – mpc) = 1/(1 –.5)

Summary: Factors that Affect Y

16 IS Curve IS curve 1.i  I  NX , Y ad , Y  Points 1, 2, 3 in figure 2.Right of IS: Y > Y ad  Y  to IS Left of IS: Y < Y ad  Y  to IS

Relation of Liquidity Preference Framework to Loanable Funds Keynes’s Major Assumption Two Categories of Assets in Wealth MoneyBonds 1.Thus:M s + B s = Wealth 2.Budget Constraint:B d + M d = Wealth 3.Therefore:M s + B s = B d + M d 4.Subtracting M d and B s from both sides: M s – M d = B d – B s Money Market Equilibrium 5.Occurs when M d = M s 6.Then M d – M s = 0 which implies that B d – B s = 0, so that B d = B s and bond market is also in equilibrium

1.Equating supply and demand for bonds as in loanable funds framework is equivalent to equating supply and demand for money as in liquidity preference framework 2.Two frameworks are closely linked, but differ in practice because liquidity preference assumes only two assets, money and bonds, and ignores effects from changes in expected returns on real assets

Liquidity Preference Analysis Derivation of Demand Curve 1.Keynes assumed money has i = 0 2.As i , relative RET e on money  (equivalently, opportunity cost of money  )  M d  3.Demand curve for money has usual downward slope Derivation of Supply curve 1.Assume that central bank controls M s and it is a fixed amount 2.M s curve is vertical line Market Equilibrium 1.Occurs when M d = M s, at i* = 15% 2.If i = 25%, M s > M d (excess supply): Price of bonds , i  to i* = 15% 3.If i =5%, M d > M s (excess demand): Price of bonds , i  to i* = 15%

Money Market Equilibrium

Rise in Income or the Price Level 1.Income , M d , M d shifts out to right 2.M s unchanged 3i* rises from i 1 to i 2

Rise in Money Supply 1.M s , M s shifts out to right 2.M d unchanged 3.i* falls from i 1 to i 2

Factors that Shift Money Demand and Supply Curves

24 LM Curve LM curve 1.Y , M d , i  Points 1, 2, 3 in figure 2.Right of LM: excess M d, i  to LMLeft of LM : excess M s, i  to LM

ISLM Model Point E, equilibrium where Y = Y ad (IS) and M d = M s (LM ) At other points like A, B, C, D, one of two markets is not in equilibrium and arrows mark movement towards point E

Shift in the IS Curve 1.C  : at given i A, Y ad , Y   IS shifts right 2.Same reasoning when I , G , NX , T 

Shift in the LM Curve from a Rise in M s 1.M s  : at given Y A, i  in panel (b) and (a)  LM shifts to the right

Shift in the LM Curve from a Rise in M d 1.M d  : at given Y A, i  in panel (b) and (a)  LM shifts to the left

Response to an Increase in M s 1.M s  : i , LM shifts right  Y  i 

Response to Expansionary Fiscal Policy 1.G  or T  : Y ad , IS shifts right  Y  i 

Summary: Factors that Shift IS and LM Curves

32 Effectiveness of Monetary and Fiscal Policy 1.M d is unrelated to i  i , M d = M s at same Y  LM vertical 2.Panel (a): G , IS shifts right  i , Y stays same (complete crowding out) 3.Panel (b): M s , Y  so M d , LM shifts right  i  Y  Conclusion: Less interest sensitive is M d, more effective is monetary policy relative to fiscal policy