The Goods Market and Money Market

7/23/2019 The Goods Market and Money Market

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The Goods Market and Money Market: Links between Them:

The Keynes in his analysis of national income explains that national income is determined at the level where

aggregate demand (i.e., aggregate expenditure) for consumption and investment goods (C +1) euals

aggregate output.

!n other words, in Keynes" simple model the level of national income is shown to #e determined #y the

goods mar$et euili#rium. !n this simple analysis of euili#rium in the goods mar$et Keynes considersinvestment to #e determined #y the rate of interest along with the marginal efficiency of capital and is shown

to #e independent of the level of national income.

The rate of interest, according to Keynes, is determined #y money mar$et euili#rium #y the demand for

and supply of money. !n this Keynes" model, changes in rate of interest either due to change in money

supply or change in demand for money will affect the determination of national income and output in the

goods mar$et through causing changes in the level of investment.

!n this way changes in money mar$et euili#rium influence the determination of national income and output

in the goods mar$et. %owever, there is apparently one flaw in the Keynesian analysis which has #een

pointed out #y some economists and has #een a su#&ect of a good deal of controversy.

!t has #een asserted that in the Keynesian model whereas the changes in rate of interest in the money mar$et

affect investment and therefore the level of income and output in the goods mar$et, there is seemingly no

inverse influence of changes in goods mar$et i.e., (investment and income) on the money mar$et

euili#rium.

!t has #een shown #y '.. %ic$s and others that with greater insights into the Keynesian theory one finds

that the changes in income caused #y changes in investment or propensity to consume in the goods mar$etalso influence the determination of interest in the money mar$et.

ccording to him, the level of income which depends on the investment and consumption demand

determines the transactions demand for money which affects the rate of interest. %ic$s, %ansen, *erner and

'ohnson have put forward a complete and integrated model #ased on the Keynesian framewor$ wherein the

varia#les such as investment, national income, rate of interest, demand for and supply of money are inter

related and mutually interdependent and can #e represented #y the two curves called the ! and *- curves.

This extended Keynesian model is therefore $nown as !*- curve model. !n this model they have shown

how the level of national income and rate of interest are &ointly determined #y the simultaneous euili#rium

in the two interdependent goods and money mar$ets. ow, this !*- curve model has #ecome a standard

tool of macroeconomics and the effects of monetary and fiscal policies are discussed using this ! and *-

curves model.

Goods Market Equilibrium: The Derivation of the is Curve:

The !*- curve model emphasises the interaction #etween the goods and money mar$ets. The goods

mar$et is in euili#rium when aggregate demand is eual to income. The aggregate demand is determined

#y consumption demand and investment demand.


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!n the Keynesian model of goods mar$et euili#rium we also now introduce the rate of interest as an

important determinant of investment. /ith this introduction of interest as a determinant of investment, the

latter now #ecomes an endogenous varia#le in the model.

/hen the rate of interest falls the level of investment increases and vice versa. Thus, changes in the rate of

interest affect aggregate demand or aggregate expenditure #y causing changes in the investment demand.

/hen the rate of interest falls, it lowers the cost c" investment pro&ects and there#y raises the profita#ility of

investment.

The #usinessmen will therefore underta$e greater investment at a lower rate of interest. The increase in

investment demand will #ring a#out increase in aggregate demand which in turn will raise the euili#rium

level of income. !n the derivation of the ! Curve we see$ to find out the euili#rium level of national

income as determined #y the euili#rium in goods mar$et #y a level of investment determined #y a given

rate of interest.

Thus ! curve relates different euili#rium levels of national income with various rates of interest. s

explained a#ove, with a fall in the rate of interest, the planned investment will increase which will cause anupward shift in aggregate demand function (C + 0) resulting in goods mar$et euili#rium at a higher level of

national income.

The lower the rate of interest, the higher will #e the euili#rium level of national income. Thus, the ! curve

is the locus of those com#inations of rate of interest and the level of national income at which goods mar$et

is in euili#rium.

%ow the ! curve is derived is illustrated in ig. 23.1. !n panel (a) of ig. 23.1 the relationship #etween rate

of interest and planned investment is depicted #y the investment demand curve !!. !t will #e seen from panel

(a) that at rate of interest 4r5the planned investment is eual to 4!5. /ith 4!5as the amount of planned

investment, the aggregate demand curve is C + !5which, as will #e seen in panel (#) of ig. 23.1 euals

aggregate output at 461level of national income.


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Therefore, in the panel (c) at the #ottom of the ig. 23.1, against rate of interest 4r2, level of income eual to

465has #een plotted. ow, if the rate of interest falls to 4r2the planned investment #y #usinessmen

increases from 4!5to 4!17see panel (a)8. /ith this increase in planned investment, the aggregate demand

curve shifts upward to the new position C + 11 in panel (#), and the goods mar$et is in euili#rium at 461

level of national income. Thus, in panel (c) at the #ottom of ig. 23.1 the level of national income 46 1is

plotted against the rate of interest, 4r1.

/ith further lowering of the rate of interest to 4r2, the planned investment increases to 4!2(see panel a).

/ith this further rise in planned investment the aggregate demand curve in panel (#) shifts upward to the

new position C + !2corresponding to which goods mar$et is in euili#rium at 462level of income.

Therefore, in panel (c) the euili#rium income 462is shown against the interest rate 4r2.

9y &oining points , 9, : representing various interestincome com#inations at which goods mar$et is in

euili#rium we o#tain the ! Curve. !t will #e o#served from ig. 23.1 that the ! Curve is downward

sloping (i.e., has a negative slope) which implies that when rate of interest declines, the euili#rium level of

national income increases.

Why does I Curve lo!e Downward"

/hat accounts for the downwardsloping nature of the ! curve. s seen a#ove, the decline in the rate of

interest #rings a#out an increase in the planned investment expenditure. The increase in investment spending

causes the aggregate demand curve to shift upward and therefore leads to the increase in the euili#rium

level of national income. Thus, a lower rate of interest is associated with a higher level of national income

and viceversa. This ma$es the ! curve, which relates the level of income with the rate of interest, to slope

downward.

teepness of the ! curve depends on (1) the elasticity of the investment demand curve, and (2) the si;e ofthe multiplier. The elasticity of investment demand signifies the degree of responsiveness of investment

spending to the changes in the rate of interest.

uppose the investment demand is highly elastic or responsive to the changes in the rate of interest, then a

given fall in the rate of interest will cause a large increase in investment demand which in turn will produce

a large upward shift in the aggregate demand curve.

large upward shift in the aggregate demand curve will #ring a#out a large expansion in the level of

national income. Thus when investment demand is more elastic to the changes in the rate of interest, the

investment demand curve will #e relatively flat (or less steep). imilarly, when investment demand is not

very sensitive or elastic to the changes in the rate of interest, the ! curve will #e relatively more steep.

The steepness of the ! curve also depends on the magnitude of the multiplier. The value of multiplier

depends on the marginal propensity to consume (mpc). !t may #e noted that the higher the marginal

propensity to consume, the aggregate demand curve (C + !) will #e more steep and the magnitude of

multiplier will #e large.

!n case of a higher marginal propensity to consume (mpc) and therefore a higher value of multiplier, a given

increment in investment demand caused #y a given fall in the rate of interest will help to #ring a#out agreater increase in euili#rium level of income.


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Thus, the higher the value of multiplier, the greater will #e the rise in euili#rium income produced #y a

given fall in the rate of interest and this ma$es the ! curve flatter. 4n the other hand, the smaller the value

of multiplier due to lower marginal propensity to consume, the smaller will #e the increase in euili#rium

level of income following a given increment in investment caused #y a given fall in the rate of interest.

Thus, in case of smaller si;e of multiplier the ! curve will #e more steep.

hift in I Curve:

!t is important to understand what determines the position of the ! curve and what causes shifts in it. !t is

the level of autonomous expenditure which determines the position of the ! curve and changes in the

autonomous expenditure cause a shift in it. 9y autonomous expenditure we mean the expenditure, #e it

investment expenditure, the


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!t is the money held for transactions motive which is a function of income. The greater the level of income,

the greater the amount of money held for transactions motive and therefore higher the level of money

demand curve.

The demand for money depends on the level of income #ecause they have to finance their expenditure, that

is, their transactions of #uying goods and services. The demand for money also depends on the rate of

interest which is the cost of holding money. This is #ecause #y holding money rather than lending it and

#uying other financial assets, one has to forgo interest.

Thus demand for money #Md$ %an be e&!ressed as:

-d = *(6, r)

/here -dstands for demand for money, 6 for real income and r for rate of interest. Thus, we can draw a

family of money demand curves at various levels of income. ow, the intersection of these various money

demand curves corresponding to different income levels with the supply curve of money fixed #y the

monetary authority would gives us the *- curve.

The *- curve relates the level of income with the rate of interest which is determined #y moneymar$et

euili#rium corresponding to different levels of demand for money. The *- curve tells what the various

rates of interest will #e (given the uantity of money and the family of demand curves for money) at

different levels of income.

9ut the money demand curve or what Keynes calls the liuidity preference curve alone cannot tell us what

exactly the rate of interest will #e. !n ig. 23.2 (a) and (#) we have derived the *- curve from a family of

demand curves for money.

s income increases, money demand curve shifts outward and therefore the rate of interest which euates

supply of money, with demand for money rises. !n ig. 23.2 (#) we measure income on the >axis and plot

the income level corresponding to the various interest rates determined at those income levels through

money mar$et euili#rium #y the euality of demand for and the supply of money in ig. 23.2 (a).

lo!e of LM Curve:


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!t will #e noticed from ig. 23.2 (#) that the *- curve slopes upward to the right. This is #ecause with

higher levels of income, demand curve for money (-d) is higher and conseuently the money mar$et

euili#rium, that is, the euality of the given money supply with money demand curve occurs at a higher

rate of interest. This implies that rate of interest varies directly with income.

!t is important to $now the factors on which the slope of the *- curve depends. There are two factors on

which the slope of the *- curve depends. irst, the responsiveness of demand for money (i.e., liuidity

preference) to the changes in income. s the income increases, say from 65to 61the demand curve for

money shifts from -d5to -d1that is, with an increase in income, demand for money would increase for

#eing held for transactions motive, -d or *1?f(6).

This extra demand for money would distur# the money mar$et euili#rium and for the euili#rium to #e

restored the rate of interest will rise to the level where the given money supply curve intersects the new

demand curve corresponding to the higher income level.

!t is worth noting that in the new euili#rium position, with the given stoc$ of money supply, money held

under the transactions motive will increase whereas the money held for speculative motive will decline.

The greater the extent to which demand for money for transactions motive increases with the increase in

income, the greater the decline in the supply of money availa#le for speculative motive and, given the

demand for money for speculative motive, the higher the rise in tie rate of interest and conseuently the

steeper the *- curve, r ? f (-2*2) where r is the rate of interest, -2is the stoc$ of money availa#le for

speculative motive and *2is the money demand or liuidity preference for speculative motive.

The second factor which determines the slope of the *- curve is the elasticity or responsiveness of demand

for money (i.e., liuidity preference for speculative motive) to the changes in rate of interest. The lower the

elasticity of liuidity preference for speculative motive with respect to the changes in the rate of interest, thesteeper will #e the *- curve. 4n the other hand, if the elasticity of liuidity preference (money demand

function) to the changes in the rate of interest is high, the *- curve will #e flatter or less steep.

hifts in the LM Curve:

nother important thing to $now a#out the !*- curve model is that what #rings a#out shifts in the *-

curve or, in other words, what determines the position of the *- curve. s seen a#ove, a *- curve is drawn

#y $eeping the stoc$ or money supply fixed.

Therefore, when the money supply increases, given the money demand function, it will lower the rate of

interest at the given level of income. This is #ecause with income fixed, the rate of interest must fall so that

demands for money for speculative and transactions motive rises to #ecome eual to the greater money

supply. This will cause the *- curve to shift outward to the right.

The other factor which causes a shift in the *- curve is the change in liuidity preference (money demand

function) for a given level of income. !f the liuidity preference function for a given level of income shifts

upward, this, given the stoc$ of money, will lead to the rise in the rate of interest for a given level of income.

This will #ring a#out a shift in the *- curve to the left.

!t therefore follows from a#ove that increase in the money demand function causes the *- curve to shift to

the left. imilarly, on the contrary, if the money demand function for a given level of income declines, it will

lower the rate of interest for a given level of income and will therefore shift the *- curve to the right.


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The LM Curve: The Essential 'eatures:

'rom our analysis of the LM %urve( we arrive at its followin) essential features:

1. The *- curve is a schedule that descri#es the com#inations of rate of interest and level of income at

which money mar$et is in euili#rium.

2. The *- curve slopes upward to the right.

@. The *- curve is flatter if the interest elasticity of demand for money is high. 4n the contrary, the *-

curve is steep if the interest elasticity demand for money is low.

3. The *- curve shifts to the right when the stoc$ of money supply is increased and it shifts to the left if the

stoc$ of money supply is reduced.

A. The *- curve shifts to the left if there is an increase in the money demand function which raises the

uantity of money demanded at the given interest rate and income level. 4n the other hand, the *- curve

shifts to the right if there is a decrease in the money demand function which lowers the amount of money

demanded at given levels of interest rate and income.

imultaneous Equilibrium of the Goods Market and Money Market:

The I and the LM %urves relate the two variables:

(a) !ncome and

(#) The rate of interest.

!ncome and the rate of interest are therefore determined together at the point of intersection of these two

curves, i.e., B in ig. 23.@. The euili#rium rate of interest thus determined is 4r2and the level of income

determined is 462. t this point income and the rate of interest stand in relation to each other such that (1)

the goods mar$et is in euili#rium, that is, the aggregate demand euals the level of aggregate output, and

(2) the demand for money is in euili#rium with the supply of money (i.e., the desired amount of money is

eual to the actual supply of money). !t should #e noted that *- cure has #een drawn #y $eeping the supply

of money fixed.


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Thus( the I*LM %urve model is based on:

(1) The investmentdemand function,

(2) The consumption function,

(@) The money demand function, and

(3) The uantity of money.

/e see, therefore, that according to the !*- curve model #oth the real factors, namely, saving and

investment, productivity of capital and propensity to consume and save, and the monetary factors, that is, the

demand for money (liuidity preference) and supply of money play a part in the &oint determination of the

rate of interest and the level of income. ny change in these factors will cause a shift in ! or *- curve and

will therefore change the euili#rium levels of the rate of interest and income.

The !*- curve model explained a#ove has succeeded in integrating the theory of money with the theory

of income determination. nd #y doing so, as we shall see #elow, it has succeeded in synthesising the

monetary and fiscal policies. urther, with the !*- curve analysis, we are #etter a#le to explain the effect

of changes in certain important economic varia#les such as desire to save, the supply of money, investment,

demand for money on the rate of interest and level of income.

Effe%t of Chan)es in u!!ly of Money on the +ate of Interest and In%ome Level:

*et us first consider what will happen if the supply of money is increased #y the action of the Central 9an$.


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lower and level of income greater than at B. ow, suppose that instead of increasing the supply of money,

Central 9an$ of the country ta$es steps to reduce the supply of money.

/ith the reduction in the supply of money, less money will #e availa#le for speculative motive at each level

of income and, as a result, the *- curve will shift to the left of B, and the ! curve remaining unchanged, in

the new euili#rium position (as shown #y point T in ig. 23.3) the rate of interest will #e higher and the

level of income smaller than #efore.

Chan)es in the Desire to ave or ,ro!ensity to Consume:

*et us consider what happens to the rate of interest when desire to save or in other words, propensity to

consume changes. /hen people"s desire to save falls, that is, when propensity to consume rises, the

aggregate demand curve will shift upward and, therefore, level of national income will rise at each rate of

interest. s a result, the ! curve will shift outward to the right.

!n ig. 23.A suppose with a certain given fall in the desire to save (or increase in the propensity to consume),

the ! curve shifts rightward to the dotted position !". /ith *- curve remaining unchanged, the new

euili#rium position will #e esta#lished at % corresponding to which rate of interest as well as level of

income will #e greater than at B.

Thus, a fall in the desire to save has led to the increase in #oth rate of interest and level of income. 4n the

other hand, if the desire to save rises, that is, if the propensity to consume falls, aggregate demand curve will

shift downward which will cause the level of national income to fall for each rate of interest and as a result

the ! curve will shift to the left.

/ith this, and *- curve remaining unchanged, the new euili#rium position will #e reached to the left of B,

say at point * (as shown in ig. 23.A) corresponding to which #oth rate of interest and level of national

income will #e smaller than at B.

Chan)es in -utonomous Investment and Government E&!enditure:

Changes in autonomous investment and


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reduces its expenditure, the ! curve will shift to the left and, given the *- curve, #oth the rate of interest

and the level of income will fall.

Chan)es in Demand for Money or Liquidity ,referen%e:

Changes in liuidity preference will #ring a#out changes in the *- curve. !f the liuidity preference or

demand for money of the people rises, the *- curve will shift to the left. This is #ecause, greater demand

for money, given the supply of money, will raise the rate of interest corresponding to each level of nationalincome. /ith the leftward shift in the *- curve, given the ! curve, the euili#rium rate of interest will rise

and the level of national income will fall.

4n the contrary, if the demand for money or liuidity preference of the people falls, the *- curve will shift

to the right. This is #ecause, given the supply of money, the rightward shift in the money demand curve

means that corresponding to each level of income there will #e lower rate of interest. /ith rightward shift in

the *- curve, given the ! curve, the euili#rium level of rate of interest will fall and the euili#rium level

of national income will increase.

/e thus see that changes in propensity to consume (or desire to save), autonomous investment or


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artificial and unrealistic. ccording to them, monetary and real sectors are uite interwoven and act and

react on each other.

urther, Datin$in has pointed out that the !*- curve model has ignored the possi#ility of changes in the

price level of commodities. ccording to him, the various economic varia#les such as supply of money,

propensity to consume or save, investment and the demand for money not only influence the rate of interest

and the level of national income #ut also the prices of commodities and services.

Datin$in has suggested a more integrated and general euili#rium approach which involves the simultaneous

determination of not only the rate of interest and the level of income #ut also of the prices of commodities

and services.

I*LM Curve Model: E&!lainin) +ole of Government.s 'is%al and Monetary ,oli%ies:

/ith the help of !*- curve model we can explain how the intervention #y the


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called Keynesian cross model) assumes that investment is fixed and autonomous, whereas !*- model

ta$es into account the fall in private investment due to the rise in interest rate that ta$es place with the

increase in


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uppose the economy is in grip of recession, the

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The Goods Market and Money Market