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The Keynesian System(II): The Keynesian System(II): Money, Interest, Money, Interest, & Income& Income
IntroductionIntroductionIn 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 demand2.that connecting money and the interest rate.
Interest Rate Interest Rate (r)(r)& AD& ADInterest rate (r)affects ADthrough IA higher rreduces I, so ADfallsKeynes believed that qty of money played a key role in determining r.The equilibrium interest rate is the rate that equates MDand MSFactors affecting MDand MSaffect r
The Theory of Liquidity Preference The Theory of Liquidity Preference (LP) (LP) LPtheory refers to money demand as measured through liquidityKeynes developed this theory which says that the equilibrium 'price' of money is the interest rateThe 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.)LPreferred to the relationship between the quantity of money the public wishes to hold and the interest rateIndividuals 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 othersHow liquid these assets are and what is the preference for being liquid of individuals (investors) will determine the portfolio distributionIf preference for liquidity is high, individuals increase holding cash
Motives of Money DemandMotives of Money DemandKeynes distinguished three “motives” for holding money:1. The “transaction motive” •People prefer to have liquidity to assure basic transactions.