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Lecture 6The Keynesian System (II):Money, Interest and IncomeReference: Froyen (Chapter 6)EIA1003MACROECONOMICS I
Interest Rate and Aggregate Demand°Fundamental to Keynesian theory°Money affects income viainterest rate:°Msincreases, 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 Y0with AD at E0=C+I0+G0 ; Corresponding interest rate is r0°When interest rate falls to r1 °AD curve shifts upward to E1=C+I1+G0 with new equilibrium at Y1°Given a change in the r, change in (Y1– Y0) 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)r0r1I0I1BAInterest rateInvestment Y0Y1BA45°Income (output)rC, I, GIYAE0=C+I0+G0Figure 6.1∆I∆IAE1=C+I1+G1a - bT0 + I0 + G0a - bT0 + I1 + G0
Contd.°I is inversely related to r.°At r0, investment is I0atA°When interest rate falls to r1, investment increases to I1atB°Since investment is a component of AE, the AE schedule moves upward.°Equilibrium point changes from A to B; and°Equilibrium income rises from Y0to Y1.
°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 haveWh ≡B + M(1)°See Figure 6.2°Money supply is fixed exogenously at Ms0°Money demand is Md°Equilibrium interest rate is r0where Ms0= Md°Equilibrium r is determined by factors affecting the MS and Md.°Msis controlled by the Central Bank and Mddepends on the motives for holding money.Keynesian Theory of Interest Rate
r0MdInterest rateQuantity of moneyrMMs0Figure 6.2 – Determination of the Equilibrium Interest Rate
°Three motives for holding money:°Transactions demand (Lt); Precautionary demand (Lp); and Speculative demand (Ls) .°Transaction:°Independent of interest rate.°Depends positively on income.°For transactions purposes.°Money as a medium of exchange.°Precautionary: °For unexpected expenditures (medical, repair).