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Froyen Chapter 6The Keynesian System (II):Money, Interest and Income
IntroductionIn this chapter, we will examine the role of money and the rate of interest We are specifically interested in the way in which these variables affect AD in the Keynesian systemRecall that in the Classical Model:Money determined the price level (QTM)The supply and demand for loanable funds determined the rate of interest Keynes rejected both of these ideas and put forward different theories of money and interest
Why Do Interest Rates Matter?
The Keynesian View of Interest Rate DeterminationOn the surface, the Keynesian view of interest rate determination appears rather simplisticThe interest rate equilibrates supply and demand for moneyThe money supply is assumed to be fixed exogenously by the central bank at M0sBut the theory becomes more complex when we consider the factors that affect the demand for moneyWith MSexogenously given, the position of the Mdcurve will determine the rate of interestShifts in either the Msor the Mdcurve will cause the interest rate to changeMdM0siMi0
The Determinants of MdSince ∆Md→ ∆ “i”→ ∆I → ∆Y, we must learn more about the determinants of MdKeynes rejected the Classical view of interest as the reward for saving moneyHe argued that interest was the reward for parting with liquidity(i.e. “not hoarding” money)He suggested that there were three motivesfor holding money:+1. Transactions Demand = ƒ (Y)+2. Precautionary Demand = ƒ (Y)-3. Speculative Demand = ƒ (i)Demand for money as an assetDesire cash balance in order to speculate about future movements in “i”Will demand more (less) cash today if interest rates are expected to rise (fall) Uncertainty