1. The Quantity Theory and the Keynesian Theory of Money

2. 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

3. Milton Friedman

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

5. 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”

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

7. Money and prices in Norway 1900-2000

8. Money and Interest Rates
The Demand for Money

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

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

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

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

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

14. 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

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

16. Money and Interest Rates
Equilibrium in the Money Market

17. The supply of money curve: (a) exogenous money supplyMS
Rate of interest O
Quantity of money

18. Equilibrium in the money marketMS
Rate of interest re O Me
Money

19. Equilibrium in the money marketMS
Rate of interest re O Me
Money

20. Relationship between the Money and Goods Markets

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

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

23. Effect of a rise in money supply: the traditional Keynesian transmission mechanismMS
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 ­

24. 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

25. 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

26. 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

27. Relationship between the Money and Goods Markets
ISLM Analysis

28. Sir John Hicks (1904 – 1989)

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. Equilibrium in both the goods and money marketsLM IS
Rate of interest O
National income

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

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

49. Equilibrium in both the goods and money marketsLM
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

50. 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

51. Equilibrium in both the goods and money marketsLM
Rate of interest re Ye IS O
National income

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

53. 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

54. 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

55. 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

56. Liquidity trap
IS` R IS LM Y

57. The classical case R
IS` IS LM Y