market in the ISLM diagram This section uses Walrass law to derive
the locus of points in the ISLM diagram at which there will be
equilibrium in the bond market. Figure 19.1 shows the standard IS and
LM curves and assumes, for simplification, a closed eco
matured. Assuming (iii) and (vi) to be equal, the loanable funds theory in
flow terms specifies the real demand (f d) and supply (f s ) functions of
loanable funds as: f s = s(r,.)+(.M0s /P md(R,.) (19) f d = i(r,.)+(g
t) (20) where: f s = real flow suppl
those wanting to borrow funds during the period. However, the flow of
funds that becomes available for loans over the current period is only a
small fraction of the total amount of credit outstanding in the economy.
This total amount is like a reservoir a
Figure 19.4 with a rightward shift in the IS curve from IS0 to IS1 due to
a budget deficit, with a consequent increase in the long-run interest rate
from rLR0 to rLR1. That is, higher deficits produce higher real rates of
interest, and eliminating them wi
outstanding bond-financed budget deficits.12 Further, the role of
financial intermediaries and the monetary base in the money creation
process were not fully understood.13 Given these simplifications, the
demand and supply functions of the loanable funds
study, the estimated coefficients for the expected rate of inflation were in
the range from 1.34 to 1.37 and, when adjusted for the tax rates, in the
range 0.97 to 1.01, so that this study supported the Fisher effect. The
Fisher effect incorporated into t
Ec > 0,Em < 0 but Eb < 0. Since IIA has Eb < 0 while IIB has Eb > 0,
the separating region between them must have Eb = 0. This is the
requirement for points on the bb curve, so that the bb curve does
differentiate between two distinctive parts of region I
Keynesian theories of the rate of interest comes down to which approach
will do better empirically in a dynamic context. However, there is no
generally accepted empirical evidence on this issue, so we should not
ignore our intuition on it. Our intuition o
demands and supplies since parts of this stock of bonds will be expected
by borrowers and lenders to mature sooner or later and, over time,
become flows available for renegotiation. The flow supply of funds can
be interpreted as that part of the stock tha
all non-monetary assets. This chapter will use these terms
interchangeably, as in Chapters 13 to 15, rather than following the
distinctive macroeconomic analysis of Chapter 16, which had two nonmonetary financial assets (bonds and credit/loans). The inter
especially the fiscal deficit. The analysis in Chapter 14 of the labor
market for the classical paradigm without uncertainty specifies the
equilibrium condition for the labor market as: nd(w) = ns (w) (8) which
determines the equilibrium real wage w, whic
> 0 = (Md t Ms t ) (31) The dynamic version of the loanable funds
theory is that changes in the rate of interest are determined by the excess
demand for bonds, with an inverse relationship: dR/dt = (Ebt) < 0 =
(Pcfw_i(R)s(R)cfw_Md t Ms t) (32) Equations (
calculated equilibrium prices will be invariant to the selection of the
three markets for the model being solved. Walrass law and different
groupings of markets in monetary and macroeconomics The preceding
analysis implies that, without changing the equil
the excess nominal demand in the Kth market to be derived from the
excess nominal demands in the other (K 1) markets. Note that we can
arbitrarily designate the market for any specific good as the Kth market.
(4) implies that: If K 1 k=1 Ed k = 0, then EK
which maintain equilibrium in the bond market, so that Eb is zero at all
points along it. By Walrass law, the equilibrium in the commodity and
money markets shown by the intersection of the IS and LM curves at
point a ensures that the bond market will als
LM a b y f rLR 0 rs r1 LM LM P y AD0 SAS a P 1 P1 P0 AD Figure
19.3 where rT is the real interest rate target, y is real output, yf is fullemployment output, is the actual inflation rate, T is the inflation rate
desired by the central bank, and the subscr
response to the excess demand for peanuts. Further, in general, the larger
the excess demand, the faster will be the price change. This adjustment
in the price of peanuts is, however, not directly influenced by the
existence and extent of disequilibrium i
the rate of interest. Section 19.8 presents the Keynesian liquidity
preference theory of interest. Section 19.9 compares the loanable funds
and liquidity preference theories in the comparative statics context and
shows that the two yield identical compara
note about this conclusion is needed: if Ricardian equivalence does not
hold (see Chapter 14 on its doubtful empirical validity), fiscal deficits do
alter the long-run real interest rate. Other determinants of the long-run
real rate of interest The other
reason has to do with the bond financing of the deficit, which increases
the supply of government bonds in the economy. Equilibrium in the
bond market requires either higher income or higher interest rates to
generate a corresponding increase in the deman
stocks, the disproportion between the borrowers and lenders is the same
as formerly, and consequently the high interest returns. (Hume, Of
Interest, 1752). The salient points of Humes conclusions can be
summarized in modern terminology as follows. 1 The l
effect of increasing money demand and has a positive expected
coefficient. The expected rate of inflation was proxied by a distributed
lag autoregressive model. Among the results reported by these authors
are: Rt = 11.276.76 ln M0t +6.03 ln yt +0.275t +jj
interest rate is often called the MundellTobin effect. Impact of high and
persistent money growth on the nominal interest rate Note the impact of
changes in the money supply on the nominal interest rate through its
impact on the real interest rate and the
rate of interest is one of the endogenous variables in the Keynesian and
classical models, so that its analysis is properly conducted as part of a
complete version of those models, which were presented in Chapters 13
to 15. This chapter singles out the co
to this is the liquidity preference concept, explained in detail later, which
would identify the interest rate with the good money, thereby making
dynamic changes in the interest rate R a function of the excess demand
for money Emtd, so that Rt/t = f (Emt
commodities markets or by making loans in the credit market, with
different individuals making this choice in different proportions. These
arguments lead to our hypothesis: the economists market for money
balances is an analytical construct without an ope
especially interesting regions are IIB and IVB. Region IIB has Em > 0
and Eb > 0. Therefore, the liquidity preference theory predicts a rise in
the interest rates while the loanable funds theory predicts a fall. In region
IVB, Em < 0 and Eb < 0, so that t
0, so that, by Walrass law, we must have Eb > 0. Hence, the bb curve
also cannot pass through quadrant III. 672 Rates of interest To
summarize, the excess demand functions for quadrants I and III are: I:
Ec > 0,Em > 0,Eb < 0 III: Ec < 0,Em < 0,Eb > 0 Sinc
saving. The modern classical economists allow such a deviation for only
unanticipated money supply changes. Therefore, the short-run deviations
of output from its full employment level under the impact of anticipated
money supply changes could, in the sho
Therefore, given the commodity demand function (7) and irrespective of
whether we use the commodity supply function of the classical or the
Keynesian paradigm, the excess demand ec d (= yd ys ) function for
commodities has the general form: Ec d = P ec d(