Relationship between the Money and Goods Markets

Relationship between the Money and Goods Markets

Effects of Monetary Changes on National Income

MONEY AND NATIONAL INCOME • The quantity theory of money
– the quantity equation: MV = PY – the stability of V – the stability of Y

• Interest-rate transmission mechanism
– stage 1: money – interest rate link – stage 2: interest rate – investment link – stage 3: multiplier effect

Effect of a rise in money supply: the traditional Keynesian transmission mechanism

MS Rate of interest

r1

L O Money

Effect of a rise in money supply: the traditional Keynesian transmission mechanism

MS Rate of interest Rate of interest L O Money O I1

r1

r1

I

Investment

Effect of a rise in money supply: the traditional Keynesian transmission mechanism

W

J1
(= I1 + G + X)

O

Y1

Effect of a rise in money supply: the traditional Keynesian transmission mechanism

MS Rate of interest

MS ' Rate of interest L

r1 r2

r1

r2 I

O Money

O

I1

I2 Investment

(a) Stage 1: MS↑ → r ↓

(b) Stage 2: r ↓ → I ↑

Effect of a rise in money supply: the traditional Keynesian transmission mechanism

W J2
(= I2 + G + X)

J1

(= I1 + G + X)

O

Y1

Y2

(c) Stage 3: I ↑ → J ↑ → Y ↑

MONEY AND NATIONAL INCOME • Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money

An elastic liquidity preference curve
MS MS' MS"

Rate of interest r1 r2

L

O Money

MONEY AND NATIONAL INCOME • Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money • unstable demand for money

The effect on interest rates of a fluctuating demand for money
MS

Rate of interest

r1

r

L' L O Money

MONEY AND NATIONAL INCOME • Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money • unstable demand for money

– possible problems with stage 2: interest rate – investment link

MONEY AND NATIONAL INCOME • Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money • unstable demand for money

– possible problems with stage 2: interest rate – investment link
• inelastic investment demand

Different views on the demand for investment

Rate of interest

r1

I O I1 Investment (a) Keynesian

Different views on the demand for investment

Rate of interest

Rate of interest

r1

r1

I

I O I1 Investment (a) Keynesian O I1 Investment (b) New classical / Monetarist

Different views on the demand for investment

Rate of interest

r2 r1

Rate of interest

r1

I

I O I2 I1 Investment (a) Keynesian O I1 Investment (b) New classical / Monetarist

Different views on the demand for investment

Rate of interest

r2 r1

Rate of interest

r2 r1

I

I O I2 I1 Investment (a) Keynesian O I2 I1 Investment

(b) New classical / Monetarist

MONEY AND NATIONAL INCOME • Limitations of the interest rate transmission mechanism
– possible problems with stage 1: money – interest rate link
• elastic demand for money • unstable demand for money

– possible problems with stage 2: interest rate – investment link
• inelastic investment demand • unstable investment demand

The effects of interest rate changes, given an unstable investment demand curve

Rate of interest

r0 r1

I1
O Q0 Q1

Investment

The effects of interest rate changes, given an unstable investment demand curve
The fall in interest rates is accompanied by an increase in business confidence

Rate of interest

r0 r1

I2 I1
O Q0 Q1 Q2

Investment

The effects of interest rate changes, given an unstable investment demand curve
The fall in interest rates is accompanied by a decrease in business confidence

Rate of interest

r0 r1

I3
O Q3 Q0 Q1

I1

Investment

MONEY AND NATIONAL INCOME • The exchange-rate transmission mechanism
– the stages
• money supply – interest rate link • interest rate – exchange rate link • exchange rate – import and export link

The exchange rate transmission mechanism

MS Rate of interest

r1

L O Money

The exchange rate transmission mechanism

MS Rate of interest Exchange rate

S1

r1

er1 D1 O

L O Money

Quantity of sterling

The exchange rate transmission mechanism

S1 Exchange rate M Exchange rate

er1

er1 D1 O Quantity of sterling

X O X1 M1 Exports (X), Imports (M)

The exchange rate transmission mechanism
W, J

W1 (= S + M1 + T)

J1 (= I + X1 + G) O Y1

Y

The exchange rate transmission mechanism

MS Rate of interest

MS ' Exchange rate

S1

r1 r2 L

er1 D1 O

O Money

Quantity of sterling

(a) Stage 1: MS↑ → r ↓

The exchange rate transmission mechanism

MS Rate of interest

MS ' Exchange rate

S1

S2

r1 r2 L

er1 er2 D2 O D1

O Money

Quantity of sterling

(a) Stage 1: MS↑ → r ↓

(b) Stage 2: MS↑ , r ↓

er ↓

The exchange rate transmission mechanism

S1 Exchange rate

S2

er1 er2 D2 D1

O

O

Quantity of sterling

(b) Stage 2: MS↑ , r ↓

er ↓

The exchange rate transmission mechanism

S1 Exchange rate M Exchange rate

S2

er1

er1 er2 D1

er2 X O M1 X2 M2 X1 Exports (X), Imports (M)

D2 O Quantity of sterling

(c) Stage 3: er ↓ →

M ↓ , X ↑(b) Stage 2: MS↑ , r ↓

er ↓

The exchange rate transmission mechanism
W, J

W1 (= S + M1 + T) W2 (= S + M2 + T) J2 (= I + X2 + G) J1 (= I + X1 + G) O Y1 Y2

Y

(d) Stage 4: M ↓ , X ↑ →

Y↑

MONEY AND NATIONAL INCOME • The exchange-rate transmission mechanism
– the stages
• money supply – interest rate link • interest rate – exchange rate link • exchange rate – import and export link

– the strength of the effect

MONEY AND NATIONAL INCOME • The exchange-rate transmission mechanism
– the stages
• money supply – interest rate link • interest rate – exchange rate link • exchange rate – import and export link

– the strength of the effect – the variability of the effect

MONEY AND NATIONAL INCOME • Portfolio balance
– the theory of portfolio balance – Keynesian criticisms – portfolio balance and the interest-rate mechanism

• The stability of the velocity of circulation
– short-run variability of V – long-run stability of V

M0 and M4 velocities of circulation
35 2.40

M0 velocity
30

2.20 2.00

M4 velocity

M0 velocity

25

1.80 1.60

20

1.40 1.20 1.00

15

10 1970

0.80 1975 1980 1985 1990 1995 2000

M0 and M4 velocities of circulation
35 2.40

M0 velocity
30

2.20 2.00

M4 velocity

M0 velocity

25

1.80 1.60

20

1.40 1.20 1.00

15

10 1970

0.80 1975 1980 1985 1990 1995 2000

M0 and M4 velocities of circulation
35 2.40

M0 velocity
30

2.20 2.00

M4 velocity

M0 velocity

25

1.80 1.60

20

1.40

M4 velocity
15

1.20 1.00

10 1970

0.80 1975 1980 1985 1990 1995 2000

Relationship between the Money and Goods Markets

Monetary Effects of Changes in the Goods Market

MONETARY EFFECTS OF GOODS MARKET CHANGES • Monetary effects of changes in aggregate demand
– effect on interest rates – effect on national income

The monetary effects of a rise in injections
W, J

W J1 O Y1

Y

(a) The goods market

The monetary effects of a rise in injections
W, J Rate of interest MS

W J1 O Y1

r1 L1 O Money (b) The money market

Y

(a) The goods market

The monetary effects of a rise in injections
W, J Rate of interest MS An expansionary fiscal policy r1 L1 O Money (b) The money market

W J2 J1 O Y1 Y2

Y

(a) The goods market

The monetary effects of a rise in injections
W, J Rate of interest MS An expansionary fiscal policy Effect on the demand for money

r2 W J2 J1 r1

L2 L1 O Money (b) The money market

O

Y1

Y2

Y

(a) The goods market

The monetary effects of a rise in injections
W, J Rate of interest MS MS 2 An expansionary fiscal policy Accommodating increase in the money supply

r2 W J2 J1 r1

L2 L1 O Money (b) The money market

O

Y1

Y2

Y

(a) The goods market

MONETARY EFFECTS OF GOODS MARKET CHANGES • Crowding out
– the analysis of crowding out – the extent of crowding out
• responsiveness of demand for money to an interest rate change • responsiveness of investment to an interest rate change

– analysis under Keynesian and monetarist assumptions

Different views on the demand for money

MS Rate of interest

r1

L

O Money (a) Keynesian

Different views on the demand for money

MS Rate of interest Rate of interest

MS

r1

L

r1 L

O Money (a) Keynesian

O

Money (b) New classical / Monetarist

Different views on the demand for money

MS Rate of interest Rate of interest

MS

r2 r1

L' L

r1 L

O Money (a) Keynesian

O

Money (b) New classical / Monetarist

Different views on the demand for money

MS Rate of interest Rate of interest

MS

r2

r2 r1

L' L

r1 L L'

O Money (a) Keynesian

O

Money (b) New classical / Monetarist

Different views on the demand for investment

Rate of interest

r1

I O I1 Investment (a) Keynesian

Different views on the demand for investment

Rate of interest

Rate of interest

r1

r1

I

I O I1 Investment (a) Keynesian O I1 Investment (b) New classical / Monetarist

Different views on the demand for investment

Rate of interest

r2 r1

Rate of interest

r1

I

I O I2 I1 Investment (a) Keynesian O I1 Investment (b) New classical / Monetarist

Different views on the demand for investment

Rate of interest

r2 r1

Rate of interest

r2 r1

I

I O I2 I1 Investment (a) Keynesian O I2 I1 Investment

(b) New classical / Monetarist

MONETARY EFFECTS OF GOODS MARKET CHANGES • Crowding out
– the analysis of crowding out – the extent of crowding out
• responsiveness of demand for money to an interest rate change • responsiveness of investment to an interest rate change

– analysis under Keynesian and monetarist assumptions

• Money supply: exogenous or endogenous?

Relationship between the Money and Goods Markets

ISLM Analysis

ISLM ANALYSIS • The goods and money markets • The IS curve
– deriving the IS curve

Goods market equilibrium: deriving the IS curve
Injections, Withdrawals Assume that an interest rate of r1 gives investment of I1 and saving of S1 S1 (W1)

O Rate of interest

I1 (J1)

r1

O

Goods market equilibrium: deriving the IS curve
Injections, Withdrawals Assume that an interest rate of r1 gives investment of I1 and saving of S1 S1 (W1)

O Rate of interest

I1 (J1) Y1

r1

O

Goods market equilibrium: deriving the IS curve
Injections, Withdrawals Assume that an interest rate of r1 gives investment of I1 and saving of S1 S1 (W1)

O Rate of interest

I1 (J1) Y1

r1

O

Y1

Goods market equilibrium: deriving the IS curve
Injections, Withdrawals Assume that an interest rate of r1 gives investment of I1 and saving of S1 S1 (W1)

O Rate of interest

I1 (J1) Y1

r1

a

O

Y1

Goods market equilibrium: deriving the IS curve
Injections, Withdrawals Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2 S1 (W1) S2 (W2) I2 (J2) I1 (J1) Y1 Y2

O Rate of interest

r1 r2

a

O

Y1

Goods market equilibrium: deriving the IS curve
Injections, Withdrawals Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2 S1 (W1) S2 (W2) I2 (J2) I1 (J1) Y1 Y2

O Rate of interest

r1 r2

a

O

Y1

Goods market equilibrium: deriving the IS curve
Injections, Withdrawals Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2 S1 (W1) S2 (W2) I2 (J2) I1 (J1) Y1 Y2

O Rate of interest

r1 r2

a b

O

Y1

Goods market equilibrium: deriving the IS curve
Injections, Withdrawals Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2 S1 (W1) S2 (W2) I2 (J2) I1 (J1) Y1 Y2

O Rate of interest

r1 r2

a b
IS (J = W) Y1

O

ISLM ANALYSIS • The goods and money markets • The IS curve
– deriving the IS curve – elasticity of the IS curve

The IS curve
Injections, Withdrawals

S1 (W1) S2 (W2) I2 (J2) I1 (J1) Y1 Y2

O Rate of interest

r1 r2

a b
IS (J = W) Y1

O

ISLM ANALYSIS • The goods and money markets • The IS curve
– deriving the IS curve – elasticity of the IS curve – shifts in the IS curve

The IS curve
Injections, Withdrawals

S1 (W1) S2 (W2) I2 (J2) I1 (J1) Y1 Y2

O Rate of interest

r1 r2

a b
IS (J = W) Y1

O

ISLM ANALYSIS • The goods and money markets • The IS curve
– deriving the IS curve – elasticity of the IS curve – shifts in the IS curve

• The LM curve

ISLM ANALYSIS • The goods and money markets • The IS curve
– deriving the IS curve – elasticity of the IS curve – shifts in the IS curve

• The LM curve
– deriving the LM curve

Money market equilibrium: deriving the LM curve
Assume that at a level of national income, Y1, the demand for money is L'

Rate of interest

L' O Money

Rate of interest O

Y1 National income

Money market equilibrium: deriving the LM curve
Assume that at a level of national income, Y1, the demand for money is L' MS Rate of interest

L' O Money

Rate of interest O

Y1 National income

Money market equilibrium: deriving the LM curve
Assume that at a level of national income, Y1, the demand for money is L' MS Rate of interest

r1 L' O Money

Rate of interest

r1

O

Y1 National income

Money market equilibrium: deriving the LM curve
Assume that at a level of national income, Y1, the demand for money is L' MS Rate of interest

Rate of interest

r1 L' O Money

r1

c

O

Y1 National income

Money market equilibrium: deriving the LM curve
Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS Rate of interest

Rate of interest

r1

L" L'

r1

c

O Money

O

Y2 Y1 National income

Money market equilibrium: deriving the LM curve
Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS Rate of interest

r2 r1 L" L'

Rate of interest

r2 r1

c

O Money

O

Y2 Y1 National income

Money market equilibrium: deriving the LM curve
Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS Rate of interest

Rate of interest

r2 r1 L" L'

r2 r1

d c

O Money

O

Y2 Y1 National income

Money market equilibrium: deriving the LM curve
Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS Rate of interest LM

Rate of interest

r2 r1 L" L'

r2 r1

d c

O Money

O

Y2 Y1 National income

ISLM ANALYSIS • The goods and money markets • The IS curve
– deriving the IS curve – elasticity of the IS curve – shifts in the IS curve

• The LM curve
– deriving the LM curve – elasticity of the LM curve

The LM curve

MS Rate of interest

LM

Rate of interest

r2 r1 L" L'

r2 r1

d c

O Money

O

Y2 Y1 National income

ISLM ANALYSIS • The goods and money markets • The IS curve
– deriving the IS curve – elasticity of the IS curve – shifts in the IS curve

• The LM curve
– deriving the LM curve – elasticity of the LM curve – shifts in the LM curve

The LM curve

MS Rate of interest

LM

Rate of interest

r2 r1 L" L'

r2 r1

d c

O Money

O

Y2 Y1 National income

ISLM ANALYSIS • The goods and money markets • The IS curve
– deriving the IS curve – elasticity of the IS curve – shifts in the IS curve

• The LM curve
– deriving the LM curve – elasticity of the LM curve – shifts in the LM curve

• Equilibrium in the model

Equilibrium in both the goods and money markets
LM

Rate of interest

IS
O National income

Equilibrium in both the goods and money markets
LM
Assume that national income is currently at a level of Y1 Rate of interest

a

IS
O Y1 National income

Equilibrium in both the goods and money markets
LM
This gives a rate of interest of r1 (point a) Rate of interest

r1

a

IS
O Y1 National income

Equilibrium in both the goods and money markets
LM
But at r1, national income is below the goods market equilibrium level (Y2) Rate of interest

r1

a

b

IS
O Y1 Y2 National income

Equilibrium in both the goods and money markets
But as income rises, so there will be a movement up the LM curve. The interest rate will rise, thereby reducing national income below Y2. Rate of interest

LM

r1

a

b

IS
O Y1 Y2 National income

Equilibrium in both the goods and money markets
LM

Rate of interest

re

IS
O Ye National income

ISLM ANALYSIS • Full effects of changes in the goods and money markets
– effects of changes in the goods market

ISLM analysis of changes in the goods and money markets
LM

Rate of interest

r1

IS
O Y1 National income

ISLM analysis of changes in the goods and money markets
LM A rise in injections
Rate of interest

r2 r1

IS2 IS1
O Y1 Y2

National income

ISLM ANALYSIS • Full effects of changes in the goods and money markets
– effects of changes in the goods market – effects of changes in the money market

ISLM analysis of changes in the goods and money markets
LM1 A rise in the money supply
Rate of interest

LM2

r1 r3

IS
O Y1 Y3

National income

ISLM ANALYSIS • Full effects of changes in the goods and money markets
– effects of changes in the goods market – effects of changes in the money market – effects of changes in both markets

ISLM analysis of changes in the goods and money markets
A rise in both injections and money supply
Rate of interest

LM1

LM2

r1

IS2 IS1
O Y1 National income Y4

ISLM ANALYSIS • Full effects of changes in the goods and money markets
– effects of changes in the goods market – effects of changes in the money market – effects of changes in both markets

• Deriving an AD curve from the ISLM model

Deriving the AD curve from an ISLM diagram
Rate of interest (r)

LM1

r1

a IS
National income (Y)

Y1

Price level (P)

P1

a'

National income (Y)

Y1

Deriving the AD curve from an ISLM diagram
Rate of interest (r)

LM2 b a

LM1

r2 r1

IS
National income (Y) Price level (P)

Y2

Y1

P2 P1

b' a' AD
National income (Y)

Y2

Y1

Relationship between the Money and Goods Markets

Taking Inflation into Account

TAKING INFLATION INTO ACCOUNT • The policy of inflation targeting • AD and AS plotted against inflation
– the inflation target line

The inflation target line

Rate of inflation (P)

.

. P

target

O

National income

TAKING INFLATION INTO ACCOUNT • The policy of inflation targeting • AD and AS plotted against inflation
– the inflation target line – the ADI curve

AD plotted against inflation
the ADI curve Rate of inflation (P)
• why downward sloping? • what determines the slope? • movements along and shifts in the ADI curve

.

. P

target

ADI
O Y1

National income

TAKING INFLATION INTO ACCOUNT • The policy of inflation targeting • AD and AS plotted against inflation
– the inflation target line – the ADI curve
• why downward sloping? • what determines the slope? • movements along and shifts in the ADI curve

– the ASI curve

AD and AS plotted against inflation
ASI Rate of inflation (P)

.

. P

a

target

ADI1
O Y1

National income

TAKING INFLATION INTO ACCOUNT • Response to change in aggregate demand and supply
– a change in aggregate demand

AD and AS plotted against inflation
ASI Rate of inflation (P)

.

. P

. P

b a c

2

target

ADI2 ADI1
O Y1 Y2 Y3

National income

AD and AS plotted against inflation
ASI Rate of inflation (P)

.

. P

. P

b a

2

target

ADI2 ADI1
O Y1 Y2

National income

TAKING INFLATION INTO ACCOUNT • Response to change in aggregate demand and supply
– a change in aggregate demand – a change in aggregate supply

TAKING INFLATION INTO ACCOUNT • Response to change in aggregate demand and supply
– a change in aggregate demand – a change in aggregate supply
• a temporary supply shock

The effects of a increase in aggregate supply
(a) a temporary increase in aggregate supply ASI1 Rate of inflation (P) ASI2

.

. P

target 2

. P

a b

ADI1
O

National income

Y1 Y2

TAKING INFLATION INTO ACCOUNT • Response to change in aggregate demand and supply
– a change in aggregate demand – a change in aggregate supply
• a temporary supply shock • a permanent change in aggregate supply

The effects of a increase in aggregate supply
(b) a permanent increase in aggregate supply ASI1 Rate of inflation (P) ASI2

.

Central bank cuts target interest rate

. P

target 2

. P

a b

c

ADI2 ADI1
O

National income

Y1 Y2

Y3

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