6.2.Keynesian System (II) - The Keynesian System(II Money Interest Income Introduction In the first part of this topic the role of money in the

# 6.2.Keynesian System (II) - The Keynesian System(II...

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The Keynesian System(II): The Keynesian System(II): Money, Interest, Money, Interest, & Income & Income
Introduction Introduction In the first part of this topic, the role of money in the Keynesian framework is explained. Fundamental to Keynes’ theory of money was his view that money affected income primarily via an effect on the interest rate. An increase in the money supply, for example, would lower the interest rate, which, in turn, would increase the level of aggregate demand and income. Therefore, to analyze the role of money, two linkages are considered: 1. that connecting the interest rate to aggregate demand 2. that connecting money and the interest rate.
Interest Rate Interest Rate (r) (r) & AD & AD Interest rate (r) affects AD through I A higher r reduces I , so AD falls Keynes believed that qty of money played a key role in determining r . The equilibrium interest rate is the rate that equates MD and MS Factors affecting MD and MS affect r
The Theory of Liquidity Preference The Theory of Liquidity Preference (LP) (LP) LP theory refers to money demand as measured through liquidity Keynes developed this theory which says that the equilibrium 'price' of money is the interest rate The theory was first to explain how the supply and demand for real money balances determine the interest rate. The intersection between money demand (MD ) curve and money supply ( MS) curve established the equilibrium rate of interest
Keynesian Liquidity Preference (Cont.) Keynesian Liquidity Preference (Cont.) LP referred to the relationship between the quantity of money the public wishes to hold and the interest rate Individuals made two decisions: The decision to save and how to hold their money (in what kind of assets). Money may be invested in bonds, t-bills, commercial paper and others How liquid these assets are and what is the preference for being liquid of individuals (investors) will determine the portfolio distribution If preference for liquidity is high, individuals increase holding cash
Motives of Money Demand Motives of Money Demand Keynes distinguished three “motives” for holding money: 1. The “transaction motive” People prefer to have liquidity to assure basic transactions.