Keynesian System2

Keynesian System2 - Keynesian System Money, Interest and...

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Keynesian System Money, Interest and Income
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Interest Rates and Aggregate Demand Interest rates can affect a number of components of aggregate demand Rising interest rates reduce business direct investment Rising interest rates reduce housing construction High short term rates raise the cost of construction High mortgage rates reduce housing demand Rising interest rates reduce durable goods purchases Rising interest rates reduce state and local borrowing and investment
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Wealth Allocation and Money People hold assets in various forms. Keynes distinguished between assets held as money (non-interest earning) and assets held as bonds (interest earning) Wh = B + M Wh = wealth (assets) B = bond holdings (all non-money assets) M = money holdings
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Transactions Demand for Money Classical economists assumed that people hold money only for transactions purposes (to buy goods and services) Transactions demand is directly related to income and inversely related to interest rates
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Precautionary and Speculative Demand for Money In addition to transactions demand, Keynes believed people hold money for two other purposes, precaution and speculation Precautionary demand – money held in for unexpected expenditures and emergencies. This demand is directly related to income. Speculative demand – money held when earnings on bonds are low, in anticipation of rising returns. This demand is inversely related to interest rates.
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Example of Speculative Demand Suppose you own a $1,000 bond that pays 5% interest into perpetuity. You make $50 per year from the bond. If interest rates, in general, are also 5%, you can sell the bond to someone else for $1,000. Next, suppose interest rates rise to 10% so that $1,000 bonds being sold today earn $100 per year. This means the value of your bond has fallen to $500.
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The Value of Holding Money Although money earns no interest, it can be a good way to hold assets to avoid becoming locked into low-performing bonds. When bonds are earning less than a critical interest rate the individual is better off waiting for interest rates to rise before purchasing bonds.
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Keynesian System2 - Keynesian System Money, Interest and...

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