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In the previous chapter, there were three effects that led to the downward slope of the aggregate
demand curve - the Pigou Wealth effect, the Keynes Interest Rate effect and the Mundell-
Fleming Exchange Rate effect. Of these three, the Keynes Interest Rate effect is by far the most
important (the Pigou effect is small because money holdings are a very small portion of
household wealth, and the Mundell-Fleming effect is small because net exports are a small
portion of GDP). This section expands on the Keynes Interest Rate effect by developing
Keynes's theory of liquidity preference.
theory of liquidity preference -
Keynes's theory that the interest rate adjusts to bring money supply and money demand
into balance .
The AD-AS model is a short-run model that
describes economic fluctuations around the long-run
trend. The theory of liquidity preference is a short-
run model of interest rate determination.
Money Supply
Money Demand
Recall that one of the reasons money has value is that money is the most liquid of all assets in the
economy. The liquidity of money comes from the fact that money IS the medium of exchange.
Because money is used to pay for goods and services, there is a demand in the economy for
people to hold cash. According to Keynes's theory of liquidity preference, the most important
determinant of money demand is the interest rate. When people hold money, they give up
interest income they could have earned had they deposited the money in a savings account or
purchased a government bond. Therefore, the interest rate is the opportunity cost of holding
money. The higher is the interest rate, the higher is the foregone interest income. For this reason,
the money demand curve has a negative slope.
NOTE: In the chapter "inflation: its causes and costs" you learned a different model of money
demand and supply. In that long-run model the only variable that affected money demand was
the price level, which was inversely related to the value of money. You should be careful to note
that the earlier model of money demand and supply and Keynes's theory of liquidity preference
are two different models. The earlier model is applicable in the long-run and the theory of
liquidity preference is applicable in the short-run.
In the money market, the equilibrium is found at the intersection of money demand and money
supply. This is the only interest rate (r*) where the quantity of money demanded EQUALS the
quantity of money supplied. At all other interest rates there will be either a shortage or surplus of
money in the economy. Shortages of money (when r < r*) will drive interest rates up and
surpluses of money (when r > r*) will drive interest rates down.
The Money Market and Aggregate Demand
There are several reasons why the higher interest rate causes the quantity of goods and services
demanded to fall. First, higher interest rates will discourage some people from borrowing money
to build a new house - thus, residential investment falls. Second, higher interest rates will
discourage firms from issuing bonds or borrowing money to build new capital - thus, business
investment falls. Finally, higher interest rates encourage people to save more money. However,
higher savings comes at the cost of lower current
consumption. All three of these effects cause the
quantity of goods and services (C + I + G + NX) to
fall.
This process will work in reverse as well. Suppose that the Fed wanted to REDUCE aggregate
demand in the economy (this is common when combating inflation). In this case, the Fed could
SELL bonds in an open market operation, INCREASE reserve ratios or INCREASE the Fed
discount rate. Each of these policy options will have the effect of decreasing the money supply
(shifting it left). A decreasing money supply causes interest rates to rise. As a result, the quantity
of goods and services demanded at all price levels falls, and the AD curve shifts to the left. This
is called restrictive monetary policy.
Changes in government spending have a direct impact on the quantity of goods and services
demanded. Since total output equals C + I + G + NX, an increase in government spending shifts
aggregate demand to the right, and a decrease in government spending shifts aggregate demand
to the left.
Changes in Taxes
Changes in taxes affect the after-tax take home pay of households in the economy. Tax cuts
increase take home pay and tax increases reduce
take home pay. When taxes are cut, consumers save
some of their new income and the remainder is spent
on consumption. Therefore, tax cuts have the effect
of increasing the quantity of goods and services
demanded (AD shifts right) and tax increases have
the effect of decreasing the quantity of goods and
services demanded (AD shifts left).
Whether the government changes its spending or changes taxes, there are two effects that
determine the overall size of a shift in AD. These effects are the multiplier effect and the
crowding out effect.
Suppose that the government permanently reduces taxes by $1million. This permanent tax cut
will have a substantial impact on AD, shifting it to the right. In the figure at right, this is depicted
by a shift from AD1 to AD2.
Now think about what households do with the extra $1million in income - they save some (say
25%), but they SPEND the rest ($750,000) on consumption (this is the cause of the initial shift in
AD). Suppose the $750,000 is spent on movie tickets.
Q: What do the employees and owners of movie theatres do with their $750,000 in new income?
A: They save some (again, say 25%) and spend the rest ($562,500) on consumption.
This process of spending and respending continues as money flows around the economy. In each
round, some of the new income gets saved and a smaller amount of income is spent on
consumption (the $562,500 in the second round was
less than the $750,000 initially spent). However,
after only two rounds, you can see that the increase
in consumption is LARGER than the size of the tax
cut ($1,312,500 > $1,000,000).
In the figure at right (bottom), a tax cut or spending increase has shifted aggregate demand to the
right (from AD1 to AD2). This increase in the quantity demanded for goods and services at ALL
prices causes an increase in the demand for money (from MD1 to MD2). In the money market
(top graph), the interest rate rises as a result of the increase in the demand for money.
Recall that rising interest rates will tend to reduce the quantity of goods and services demanded
at ALL price levels, partly because higher interest rates make borrowing money for investing in
new capital MORE costly. This reduction in the quantity of goods and services demanded shifts
aggregate demand back to the left (from AD2 to AD3).
The crowding out effect is the offset in aggregate demand that results when expansionary fiscal
policy raises the interest rate and thereby reduces investment spending. Crowding out implies
that the size of the shift in AD resulting from a spending or tax change may be SMALLER than
the size of the original change.
The overall effect of a spending or tax change will depend BOTH on the size of the multiplier
effect and the crowding out effect. If the multiplier effect is larger, the shift in AD will be larger
than the original change. If the crowding out effect is larger, the shift in AD will be smaller than
the original change.
The figures above depict two short-run situations that call for stabilization policy - either AD is
insufficient (left figure) or AD is excessive (right figure). Stabilization policy refers to the use of
monetary and fiscal policy to reduce short-run economic fluctuations.
Alternatively, a wave of consumer optimism may have pushed the economy beyond the natural
rate of output (this is the right figure, and AD = AD2). Output in the economy (Y1) exceeds the
natural rate of output, and unemployment is LOWER than the natural rate of unemployment.
This situation is inflationary, and economists will often describe the economy as "overheating"
when this occurs. There are still 3 appropriate stabilization policies in this situation (they're just
the reverse of the previous case): first, the Fed could shrink the money supply, which raises
interest rates and shifts AD to the left (towards AD0); second, the government could increase
taxes (again shifting AD towards AD0); third, the government could cut its spending on goods
and services (also shifting AD towards AD0).
The argument FOR the active use of stabilization policy is straightforward - BOTH recessions
and inflations are undesirable. If the government and the fed can actively manipulate AD to
reduce the size of short-run fluctuations, the costs of recessions and inflations can be avoided.
While the previous analysis may lead you to think that stabilization policies SHOULD be used,
there are solid arguments against using them. The argument most often cited is that both
monetary and fiscal policies work with a substantial lag. For monetary policy, realize that
households and firms plan their investment expenditures (whether on a new house or on plant
and equipment) in advance - therefore, a change in the interest rate may NOT change investment
spending immediately. Fiscal policy has a more complicated lag - any change in government
spending or taxation has to FIRST go through the congress, and SECOND be signed by the
President. This political process can take months or years.
The problem with using stabilization policies in the face of lags is that economic situations may
change between the implementation of the policy and its effect on the economy. It's very possible
that, by the time stabilization policy takes effect, policymakers don't want it anymore.
Additionally, the use of stabilization policy, because of the lags, requires accurate forecasting of
future economic conditions. As your textbook points out, economic forecasting is imprecise.
The makeup of the tax and spending system includes automatic stabilizers, or changes in
spending and taxes that react automatically to changes in economic conditions. Most taxes in the
economy are tied to the level of economic activity - income taxes, payroll taxes corporate taxes,
etc. As the economy falls into a recession, income, earnings and profits all fall together, and tax
collections fall as well, but this automatic tax cut IS a stabilization policy, and it works without a
lag. Government spending also has a stabilizing influence. When the economy falls into a
recession, welfare benefits and unemployment insurance increase (these BOTH increase
government spending). Again, this automatic increase in government spending IS a stabilization
policy. These automatic stabilizers also work in the face of inflation. With inflation, taxes
automatically rise (as incomes rise) and government spending falls (as unemployment insurance
and welfare benefits fall).
Because automatic stabilizers help to reduce the size of short-run economic fluctuations, many
economists oppose legislation that would force the government to balance its budget. When there
is a recession, taxes automatically fall and spending automatically rises, leading to a deficit. With
inflation, taxes automatically rise and spending automatically falls, leading to a surplus. This is
how the automatic stabilizers work. Strict balanced budget amendments would eliminate the
actions of the automatic stabilizers.
If the terms affecting money demand are stable, then money demand itself will be stable. Also,
velocity will be fairly predictable.
IV. Empirical Evidence on Money Demand
So who is right? Well, the chief differences between Keynes and Friedman lie in the sensitivity
of money demand to interest rates and the stability of the money demand function over time.
Looking at the data on these two features will yield some answers about the best theory of
money demand.
Tobin did some of the earliest research on the relationship between interest rates and money
demand and concluded that money demand IS sensitive to interest rates. Later research in the
1950s and 1960s backed up his findings. Furthermore, the sensitivity did not change over time.
Many researchers looked at this question and their findings are remarkably consistent (which in
economics is somewhat miraculous :)).
Now for the stability of the money demand function. Up until the mid-1970s, researchers found
the money demand function to be remarkably stable. In other words, money demand functions
estimated in the 1930s, worked just as well predicting money demand in the 1950s or 1960s. The
relationship between money demand, income and interest rates did not change over time.
However, starting in 1974, the stability of the money demand function (M1) began to
breakdown. Existing money demand functions were overpredicting money demand (i.e. actual
money demand was lower than what old money demand functions were predicting). This case of
the "missing money" was a problem for policy makers that relied on these functions to predict
the effects of monetary policy. What caused this breakdown? It is likely that financial
innovations in the 1970s (money market accounts, NOW accounts, electronic funds transfers)
changed the working definitions of money even though our official definitions did not change.
This problem grew worse in the 1980s.
With the problems in the M1 money demand functions, policy makers turned to M2 money
demand. However, the stability of M2 money demand functions also broke down in the 1990s.
This cause the Federal Reserve to stop setting targets for M2 in 1992 after abandoning M1
targets in 1987.