L6 - EIA1003 MACROECONOMICS I Lecture 6 The Keynesian...

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Lecture 6 The Keynesian System (II): Money, Interest and Income Reference: Froyen (Chapter 6) EIA1003 MACROECONOMICS I
Interest Rate and Aggregate Demand ° Fundamental to Keynesian theory ° Money affects income via interest rate: ° M s increases, lowers interest rate (r); and ° Lower interest rate (r), increases AD and Y. ° 2 important relationships: ° Money (M) and interest rate (r); and ° Effect of interest rate (r) on AD. ° Interest rates and AD ° Changes in interest rate (r) affect components of AD; ° Investment (I), consumer expenditure on durable goods (C), subcomponents of government expenditure (G).
° See Figure 6.1 ° Initial equilibrium: ° At Y 0 with AD at E 0 =C+I 0 +G 0 ; Corresponding interest rate is r 0 ° When interest rate falls to r 1 ° AD curve shifts upward to E 1 =C+I 1 +G 0 with new equilibrium at Y 1 ° Given a change in the r, change in (Y 1 – Y 0 ) depends on the size of the shift in AD caused by the change in r. ° The more sensitive the components of AD are to r changes, the larger will be the shift in AD function and greater the effect on Y; ° Therefore, interest sensitivity of AD is important in determining how effective monetary policy will be in affecting equilibrium Y. Contd.
Effect Of A Decrease in Interest Rate On Investment And Equilibrium Income (a) Investment (I) Schedule (b) Aggregate Expenditure (AE) r 0 r 1 I 0 I 1 B A Interest rate Investment Y 0 Y 1 B A 45 ° Income (output) r C, I, G I Y AE 0 =C+I 0 +G 0 Figure 6.1 I I AE 1 =C+I 1 +G 1 a - bT 0 + I 0 + G 0 a - bT 0 + I 1 + G 0
Contd. ° I is inversely related to r. ° At r 0 , investment is I 0 at A ° When interest rate falls to r 1 , investment increases to I 1 at B ° Since investment is a component of AE, the AE schedule moves upward. ° Equilibrium point changes from A to B; and ° Equilibrium income rises from Y 0 to Y 1 .
° Keynes assume individuals allocate their financial wealth between two assets, money ( M ) and Bonds ( B ) ° At a point in time, wealth (Wh) is fixed at some level ° Since M and B are the only stores of wealth, we have Wh B + M (1) ° See Figure 6.2 ° Money supply is fixed exogenously at M s 0 ° Money demand is M d ° Equilibrium interest rate is r 0 where M s 0 = M d ° Equilibrium r is determined by factors affecting the M S and M d . ° M s is controlled by the Central Bank and M d depends on the motives for holding money. Keynesian Theory of Interest Rate
r 0 M d Interest rate Quantity of money r M M s 0 Figure 6.2 – Determination of the Equilibrium Interest Rate
° Three motives for holding money: ° Transactions demand (L t ); Precautionary demand (L p ); and Speculative demand (L s ) . ° Transaction: ° Independent of interest rate. ° Depends positively on income. ° For transactions purposes. ° Money as a medium of exchange. ° Precautionary: ° For unexpected expenditures (medical, repair).

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