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Liquidity Preference Theory
Transactions Motive—yields transactions
demand for money
Store of Value—yields:
– Precautionary Motive—yielding precautionary
demand for money
– Speculative Motive—yielding the speculative
demand for money
There are reasons why someone might
rationally hoard money!
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Speculative Demand (1)
Keynes considers a portfolio of
financial assets.
All financial assets can be
considered as money or bonds:
– Money (M): yields no return
– Bonds (B): yield a return
Wh = M + B
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Speculative Demand (2)
Example—Perpetuity (a bond that never
matures):
– Bond is issued at $1000
– Coupon rate is $50 50/1000=5%
– Later, market interest double to 10%
– How much can you sell the bond for?
– Ans: $500 because 50/500=10%
When interest rates rise, bond prices fall
capital losses!
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Speculative Demand (3)
People decide to hold money
r instead of bonds when interest
rates get so low that they cannot
possibly go lower. The move to
money to avoid capital losses.
There is a rational motive for
hoarding money!!!
M d
Lp = Lp(r)
r0 (-)
As interest rates fall,
Bd 0 and Md .
M
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Precautionary Demand
People hold money (“precautionary
balances”) for unforeseeable
expenses.
These holdings (“balances”) tend to:
– Rise with income, and
– Fall with interest rates.
Lp = Lp(Y,r)
(+) (-)
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Ambiguity in the Money Market
In the classical model:
– Ms = M0 (exogenous)
– Md = Md(Y)
– We used these relationships to create the AD
curve.
In Keynes’ model:
– Ms = M0 (exogenous)
– Md = L(Y,r)
– Ms = M d
– M0 = L(Y,r) is the money market outcome.
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Sidenote: Hicks’ Little Apparatus
Sir John Hicks, 1939, “Mr Keynes
and the Classics, a Suggested
Interpretation”
Introduces the IS-LM Model as a way
of making sense of Keynes’ General
Theory.
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Keynesian “Money Market”
M0 = L(Y,r) is the equilibrium in the money
market.
There is not one single variable that can
change to clear the market. There are two!
The “money market” cannot tell us alone
what the supply and demand for money
will be.
Money is not dichotomous.
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Hicks’ Interpretation: LM Curve
r LM Curve (L=M): all
LM those combinations of
real interest rates and
income which bring the
money supply equal to
money demand.
Y
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LM Curve Slopes Upward Because...
Assumes Ms = M0 r Ms
(exogenous)
If Y increases, transactions
and precautionary demand
increase. Md(Y1)
– There will be excess r1
demand in the money Md(Y0)
markets r0
– Interest rates will be driven
upward
M
So Y r, and the LM
Curve slopes upward.
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LM Curve Slopes Upward Because...
Md(Y2)
r1 Md(Y1)
r0 Md(Y0)
M Y0 Y1 Y2 Y
15
Changes in Money Supply
r Ms Ms Ms
Ms
r* Md
M
s
M
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Capital Market
Investment I = I(r,E) = I(r)
But Saving S = S(Y) or S(Yd)
So there is not a single “price variable” to clear the capital
market!
I(r) = S(Y) IS Curve: IS = IS(Y,r)
IS: all those combinations of Y and r which make the
“capital market” clear.
Equivalently, IS is all those combinations of Y and r for
which supply = demand in the loanable funds market.
Thus the real sector cannot be resolved without
considering money market outcomes.
– Money is NOT dichotomous.
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IS Curve
r
IS
Y
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IS Curve Slopes Downward Because...
Recall that:
I+T=S+G
or
I(r) + T0 = S(Y) + G0
Differentiate implicitly with respect to Y and r:
ds
dr dY ()
0
dY dI ( )
dr
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r S
S
I0 = S0
r2
r1 I1 = S1
r0 I I2 = S2
I2 I1 I0 I Y2 Y1 Y0 Y
r2
r1
r0 IS
Y2 Y1 Y0 Y 20
Money and Investment
The interest rate is
determined in the
money market.
Decision makers in
r r firms compare this
Ms rate to the MEC and
make the decision
regarding
investment.
r*
Md I
M* M I* I
The real and monetary sectors are
linked. Money matters! 21
IS-LM
Note that the real
r and monetary
LM
sectors of the
economy are
resolved together.
r* Money matters to
real sector
outcomes.
IS
There is no
Y* Y dichotomy.
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Money-Income Transmission
The Keynes Effect (Money Income Transmission Mechanism):
I
M s B d PB r AD P
Cdurables
• Money is not neutral (in the short run), and there is no
dichotomy.
M
LM : kY r IS : I G S T
P
I I0 r
M
r kY S S0 (1 c )(Y T )
P
M k I0 r G0 S0 (1 c )(Y T ) T
r Y
P r (S0 I0 G0 ) (1 c )Y T cT T
r (S0 I0 G0 cT ) (1 c )Y
(I0 G0 S0 cT ) 1 c
r Y
25
Linearized IS-LM
r k
LM
I0 G0 S0 cT0
(1 c )
r*
IS
M
Y
Y*
P
26
Classical Model? (=0)
r LM
I0 G0 S0 cT0
(1 c )
r*
IS
Y
Y*
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