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Quantity Theory of Quantity Theory of MoneyMoney
VelocityVelocityP P Y Y
VV = =MM
Equation of Exchange Equation of Exchange M M V V = = P P Y Y
Quantity Theory of MoneyQuantity Theory of Money
1. Irving Fisher’s view: 1. Irving Fisher’s view: VV is fairly constant is fairly constant2. Equation of exchange no longer identity2. Equation of exchange no longer identity3. Nominal income, 3. Nominal income, PYPY, determined by , determined by MM4. Classicals assume 4. Classicals assume YY is determined by real factors, is determined by real factors, not monetarynot monetary5.5. P P determined by determined by MM
Quantity Theory of Money DemandQuantity Theory of Money Demand
1 1 MM = = PY PY VV
MMdd = = kk PYPY
Implication:Implication: interest rates not important to interest rates not important to MMdd
Cambridge ApproachCambridge Approach
Is velocity constant?Is velocity constant?1.1. Classicals thought Classicals thought VV
constant because didn’t have constant because didn’t have good datagood data
2.2. After Great Depression, After Great Depression, economists realized velocity economists realized velocity far from constantfar from constant
Keynes’s Liquidity Keynes’s Liquidity Preference TheoryPreference Theory
3 Motives3 Motives
1.1. Transactions motive—related to Transactions motive—related to YY
2.2. Precautionary motive—constantPrecautionary motive—constant
3.3. Speculative motiveSpeculative motive
A. related to A. related to WW and and YY
B. negatively related to B. negatively related to ii
Liquidity PreferenceLiquidity Preference
MMdd
= f(= f(i, Yi, Y)) PP – + – +
Keynes’s Liquidity Keynes’s Liquidity Preference TheoryPreference Theory
Implication: Velocity not constantImplication: Velocity not constant
PP 1 1 == MMdd f( f(i,Yi,Y))
Multiply both sides by Multiply both sides by YY and substitute in and substitute in MM = = MMdd
PYPY Y YVV = = = =
MM f( f(i,Yi,Y))
1. 1. ii , f(, f(i,Yi,Y) ) , , VV 2. Change in expectations of future 2. Change in expectations of future ii or change or change
f(f(i,Yi,Y) results in a change in ) results in a change in VV
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Determination of OutputDetermination of OutputKeynesian Keynesian IS-LMIS-LM Model assumes price level is fixed Model assumes price level is fixed
Aggregate DemandAggregate Demand
YYadad = = CC + + II + + GG + + NXNX
EquilibriumEquilibrium
YY = = YYadad
Consumption FunctionConsumption Function
CC = = aa + ( + (mpcmpc YYDD))
InvestmentInvestment
1.1. Fixed investmentFixed investment
2.2. Inventory investmentInventory investment
Only planned investment is included in Only planned investment is included in YYadad
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Keynesian Cross Keynesian Cross DiagramDiagram
Assume G = 0, NX = 0, T = 0
Yad = C + I = 200 + .5Y + 300 = 500 + .5Y
Equilibrium:1. When Y > Y*, Iu > 0 Y
to Y*2. When Y < Y*, Iu < 0 Y
to Y*
Analysis of Figure 3: Analysis of Figure 3: Expenditure MultiplierExpenditure Multiplier
II = + 100 = + 100 YY//II = 200/100 = 2 = 200/100 = 211
YY = ( = (aa + + II) ) 1 – 1 – mpcmpcAA = = aa + + II = autonomous spending = autonomous spending
Conclusions:Conclusions:
1.1. Expenditure multiplier = Expenditure multiplier = YY//AA = 1/(1 – = 1/(1 – mpcmpc))whether change in whether change in AA is due to change in is due to change in aa or or II
2.2. Animal spirits change Animal spirits change AA
The Great Depression The Great Depression and the Collapse of and the Collapse of
InvestmentInvestment
Analysis of Figure 5: Analysis of Figure 5: Role of GovernmentRole of Government
GG = + 400, = + 400, TT = + 400 = + 400
1.1. With no With no GG and and TT, , YYdd = = CC + + II = 500 + = 500 + mpc mpc YY = 500 + .5 = 500 + .5YY, , YY11 = 1000 = 1000
2.2. With With GG, , YY= = CC + + II + + GG = 900 + .5 = 900 + .5YY, , YY22 = 1800 = 1800
3.3. With With GG and and TT, , YYdd = 900 + = 900 + mpc mpc YY – – mpc mpc T = 700 + .5T = 700 + .5YY, , YY33 = 1400 = 1400
Conclusions:Conclusions:
1.1. GG YY ; ; TT YY 2.2. G G = = T T = + 400, = + 400, YY 400 400
Role of International Role of International TradeTrade
NX = +100,Y/NX = 200/100 = 2
= 1/(1 – mpc) = 1/(1 – .5)
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ISIS CurveCurve
IS curve1. i I NX ,
Yad , Y Points 1, 2, 3 in figure
2. Right of IS: Y > Yad Y to ISLeft of IS: Y < Yad Y to IS
Relation of Liquidity Relation of Liquidity PreferencePreference
Framework to Loanable Framework to Loanable FundsFundsKeynes’s Major AssumptionKeynes’s Major Assumption
Two Categories of Assets in WealthTwo Categories of Assets in Wealth
MoneyMoney
BondsBonds
1.1. Thus:Thus: MMss + + BBss = Wealth = Wealth
2.2. Budget Constraint:Budget Constraint: BBdd + + MMdd = Wealth = Wealth
3.3. Therefore:Therefore: MMss + + BBss = = BBdd + + MMdd
4.4. Subtracting Subtracting MMdd and and BBss from both sides: from both sides:
MMss – – MMdd = = BBdd – – BBss
Money Market EquilibriumMoney Market Equilibrium
5.5. Occurs when Occurs when MMdd = = MMss
6.6. Then Then MMdd – – MMss = 0 which implies that = 0 which implies that BBdd – – BBss = 0, so that = 0, so that BBdd = = BBss and bond market is also in equilibrium and bond market is also in equilibrium
1.1. Equating supply and demand for bonds Equating supply and demand for bonds as in loanable funds framework is as in loanable funds framework is equivalent to equating supply and demand equivalent to equating supply and demand for money as in liquidity preference for money as in liquidity preference frameworkframework
2.2. Two frameworks are closely linked, but Two frameworks are closely linked, but differ in practice because liquidity differ in practice because liquidity preference assumes only two assets, preference assumes only two assets, money and bonds, and ignores effects from money and bonds, and ignores effects from changes in expected returns on real assetschanges in expected returns on real assets
Liquidity Preference Liquidity Preference AnalysisAnalysisDerivation of Demand CurveDerivation of Demand Curve
1.1. Keynes assumed money has Keynes assumed money has ii = 0 = 0
2.2. As As ii , relative , relative RETRETee on money on money (equivalently, (equivalently,
opportunity cost of money opportunity cost of money ) ) MMdd
3.3. Demand curve for money has usual downward slopeDemand curve for money has usual downward slope
Derivation of Supply curveDerivation of Supply curve
1.1. Assume that central bank controls Assume that central bank controls MMss and it is a fixed and it is a fixed
amountamount
2.2. MMss curve is vertical line curve is vertical line
Market EquilibriumMarket Equilibrium
1.1. Occurs when Occurs when MMdd = = MM
ss, at , at ii* = 15%* = 15%
2.2. If i = 25%, If i = 25%, MMss > > MM
dd (excess supply): Price of bonds (excess supply): Price of bonds , , ii
to to ii* = 15%* = 15%
3.3. If If ii =5%, =5%, MMdd > > MM
ss (excess demand): Price of bonds (excess demand): Price of bonds , , ii
to to ii* = 15%* = 15%
Rise in Income or the Rise in Income or the Price LevelPrice Level
1.1. Income Income , , MMdd , , MMdd shifts out to rightshifts out to right
2.2. MMss unchanged unchanged
33 ii* rises from * rises from ii11 to to ii22
Rise in Money SupplyRise in Money Supply
1.1. MMss , , MMss shifts out shifts out to rightto right
2.2. MMdd unchanged unchanged
3.3. ii* falls from * falls from ii11 to to ii
22
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LMLM Curve Curve
LM curve1. Y , Md , i Points 1, 2, 3 in figure2. Right of LM: excess Md, i to LMLeft of LM : excess Ms, i to LM
ISLISLM M
ModModelel
Point E, equilibrium where Y = Yad (IS) and Md = M s (LM )At other points like A, B, C, D, one of two markets is not in equilibrium and arrows mark movement towards point E
Shift Shift in the in the
ISIS CurveCurve
1. C : at given iA, Yad ,
Y IS shifts right2. Same reasoning when
I , G , NX , T
Shift in the Shift in the LMLM Curve from a Curve from a Rise in Rise in MMss
1. Ms : at given YA, i in panel (b) and (a) LM shifts to the right
Shift in the Shift in the LMLM Curve from a Curve from a Rise in Rise in MM d d
1. M d : at given YA, i in panel (b) and (a) LM shifts to the left
Response to Expansionary Response to Expansionary Fiscal PolicyFiscal Policy
1. G or T : Yad , IS shifts right Y i
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EffectivenEffectiveness of ess of
Monetary Monetary and Fiscal and Fiscal
PolicyPolicy
1. M d is unrelated to i i , M d = M s at same Y LM vertical
2. Panel (a): G , IS shifts right i , Y stays same (complete crowding out)
3. Panel (b): M s , Y so M d , LM shifts right i Y Conclusion: Less interest sensitive is M d, more effective is monetary policy relative to fiscal policy
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