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ISLM Analysis Part II: The Monetary Sector (The Hard-Drawn Keynesian View) The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2010 Keynes had once considered himself to be a “classical” economist. With Marshall, he believed that 1. the interest rate is determined in the loanable-funds market and 2. money is to be analyzed in terms of the equation of exchange. He later concluded that the interest rate wasn’t doing its job—because saving was not affected by the interest rate and investment was governed exclusively (or, at least, primarily) by psychological factors. He also concluded that the equation of exchange should be jettisoned (or, at least, should have greatly diminished significance)—because it stood in the way of our recognizing the impact that monetary disturbances can have on the economy’s real sector. Keynes had once considered himself to be a “classical” economist. With Marshall, he believed that 1. the interest rate is determined in the loanable-funds market and 2. money is to be analyzed in terms of the equation of exchange. Keynes was left with two puzzles: 1. What job is the interest rate actually doing? and 2. What replaces the equation of exchange? Keynes then had a Road-to-Damascus conversion: There is a single answer to both questions: The supply and demand for money are brought into balance by adjustments in the interest rate! According to Keynes, the interest rate has little or no influence on people’s willingness to save. But it has a great influence, he claims, on the preferred KEYNES’S LIQUIDITY-PREFERENCE THEORY OF INTEREST form of saving. Do people put their savings at interest (e.g. by buying bonds) or do they keep their savings liquid (by holding money)? Income alone determines consumption behavior. Then, the interest rate (or rather, the expected direction of movement in the interest rate) affects the relative attractiveness of money and bonds. Y C = a + bY B (if the interest rate is expected to fall) S = -a + (1-b)Y M (if the interest rate is expected to rise) Suppose that a Railroad issues a 6%, 30 year, $1,000 bond in 1872. The bond, which sells for about $1,000, has 60 coupons attached. These coupons are redeemable for $30 each at six-month intervals. $1,000 What paidisata bond? maturity. When the last coupon is redeemed, the $1,000 is returned to the bond holder. $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 The buyer pays about $1,000 in 1872. $30 $30 $30 $30 $30 $30 He gets back $1,000 in 1902. $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 And he gets $30 biannually for 30 years. $30 $30 $30 $30 $30 $30 He can sell the bond any time he wants. $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 But the selling price might be less than, more than, or equal to $1,000. How so? Suppose that a few years after you bought this bond, market rates of interest are significantly lower higherthan than6%. 6%. At that point, the someone $1,000-bond might be rate able might to buyasa low be 9% bond as 4%orora 3%. 12%These bond. bonds These $1,000have would bonds a six-month would have coupon a coupon value of valueorof$15, $20 $45respectively. and $60, respectively. You could easily still sellsell your your 6%6% bond, bond, butand you would be have able to offer to sellit itatata aprice price considerably higher less than than $1,000. $1,000. From a 1993 OECD OUTLOOK: In the United States, long-term railroad-bond yields fell gradually from about 5 per cent in 1880 to 4 per cent at the turn of the century then rose slightly. $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 Keynes portrayed each saver as facing a choice between holding his savings liquid or holding long-term bonds. The savers’ preferences in this regard determine both the demand for money (liquidity) and the demand for earning assets (bonds). i The choices (between money and bonds) hinge critically on beliefs about future movements in the interest rate. MSPEC In this connection, the demand for money is a speculative demand (MSPEC) whose magnitude is related, though widely-held views about the “normal” rate of interest, to the current rate of interest. If a high current rate of interest implies that rates are likely to fall and a low current rate implies that they are likely to rise, then we get a downward-sloping demand for speculative money holdings. Keynes believed that the demand for money holdings, i.e., for liquidity, is fairly interest-rate elastic—especially at low rates of interest. i MSPEC If the current rate is sufficiently high, savers will lock themselves into a high long-term bond rate, and the quantity of money holdings demanded will be zero. If the current rate is sufficiently low, savers will abstain from buying bonds and will hold all their savings liquid. The elasticity of money demand becomes infinite. The speculative demand for money is unique to Keynesian macroeconomics and, according to some, is the sine qua non of Keynesianism. CLASSICAL REGION This special demand curve is non-linear and has three identifiable regions: i EXTREME KEYNESIAN REGION MSPEC In the At rates “intermediate of interest soregion,” highthat low that thevirtually virtually quantityno noof one believes money holdings theydemanded are likely to varies go still inversely lower, higher, the with speculative thethe ratespeculative of interest. demanddemand for money for money is perfectlyperfectly becomes inelasticelastic. and isInco-incident this “extreme with the vertical region,” Keynesian axis. This allisadditions the “classical to the region,”supply money so named are simply because hoarded. in the classical theory, there is no speculative demand for money. Complicating matters, the demand for money holdings, like the demand for investment funds, is unstable. While investment is governed by “animal spirits,” money hoarding is rooted in the “fetish of liquidity.” i MSPEC Expectations about which direction the interest rate is likely to move can become unanchored. The shifting and drifting expectational winds can send the demand for money holdings right and left or up and down. Just as “animal spirits” dominate the demand for loanable funds, the demonized miser dominates the demand for speculative money holdings. If the demand for money holdings stays put for the time being, we can note the inverse relationship between the interest rate and the demand for money holdings. i To determine the particular rate of interest that actually prevails, we take into account the money supply, which is set by the central bank. MS ieq MSPEC The rate of interest adjusts to its equilibrium value (ieq), where the preferred level of money holdings is equal to the money supply. This the hard-drawn Keynesian view, where “forces of a different kind” (and not the loanable-funds market) determine the market-clearing rate of interest. If the demand for money holdings stays put for the time being, we can note the inverse relationship between the interest Robertson of interest: rate andon theKeynes’s demand theory for money holdings. i “The interest rate rateof is what it To determine the particular is because it is expected to interest that actually prevails, we take be other than what it is. If it into account the money supply, which is isn’t expected to be other thanbank. what it is, there is set by the central MS ieq MSPEC nothing to tell us why it is The rate of interest its that what adjusts it is. Thetoorgan equilibrium value (ieq), where secretes it has the been and yet is preferred levelamputated of money holdings somehow it still exists, the equal to the money supply. Dennis Robertson grin without the cat.” This the hard-drawn Keynesian view, where “forces of a different kind” (and not the loanable-funds market) determine the market-clearing rate of interest. (1890−1963) Suppose that people’s propensity to hoard strengthens—meaning that their demand for money to hold increases. i Note that the increased demand is not automatically accommodated by an increase in the money supply. Instead, the rate of interest rises until people are content to hold the existing money supply. MS i’eq ieq MSPEC However, if the central bank wants to reestablish the pre-existing rate of interest, it can increase the money supply, moving the money holders along their moneydemand curves. i ieq With an economy performing at fullemployment without inflation, Keynes argued that changes in money demand should be accommodated by corresponding changes in the money supply. He did not want increased money demand to be choked off by an increase in the rate of interest. MS MS MSPEC If the central bank could synchronize movements in the money supply with movements in money demand, the interest rate would not need to change. Note that successful synchronization effectively transforms a perfectly inelastic money supply into a perfectly elastic money supply. So, why does it matter that the interest rate increases with a strengthening of hoarding propensities? i S S Seq W S Y MS i’eq ieq MSPEC It matters because a change in the interest rate has an impact on the real sector of the economy. D I i i N 1 Suppose the economy is ΔI in an incomeΔY = (1 – b) expenditure equilibrium and is performing at full ieqemployment without inflation. That is, labor IS enough to clear the labor demand isΔYjust strong ΔI market at the going wage. Ieq Yeq Y I An increase in money demand raises the rate of interest and takes this fully-employed economy into recession. An accommodating increase in the money supply undoes the damage. S S Seq i ieq i MS MS MSPEC ieq Y I i IS Yeq Y Ieq I People behave fetishistically money, By continuously manipulatingtoward the money supply sometimes wanting to hoard If thechanging, central bank so as to keep the interest rateit.from the matchesbank theircan hoarding propensities by supplying central nip in the bud any recession (or additionalthat quantities of money,be theassociated economy will inflation) would otherwise with be spared from spiraling depression. the unstable demand for into money. S S Seq W S i i MS ieq ieq MSPEC Y i D I N IS Yeq Y Ieq I We begin again with the economy in an incomeexpenditure equilibrium and performing at full employment without inflation. We assume away the problem of hoarding and show how monetary policy can counter a waning of animal spirits. S Suppose the animal spirits are on the wane, causing investors to cut Seq back on their borrowing S'eq of investment funds. i i MS ieq ieq MSPEC S W W S Y ΔY i 1 ΔY = (1 – b) ΔI S D D I N ΔI N IS Y'eq Yeq Y I'eq Ieq I In The themagnitude absence any the shift fiscal-policy in the IS levers, curvethe is theaISrecession multiple ofcan thetobe magnitude countered of by With the change investment behavior, curve shifts the left. Finally, note thatofin the decrease in income reflects a corresponding decrease the monetary shift inpolicy. the has demand for strictly investment funds. by the Here, shape the ofpersisting, simple thelevels demand Keynesian for in the demand forThough labor. And withalimited the going wage rate theincome, labor The economy experienced downturn in which lower of money, increase in the money lowerdisequilibrium. therate rateofofinterest, interest and multiplier in play. And note that supply with ancan unchanged the market isanis experiencing aare persistent (Marshallian) Keynes investment, and saving established. move the economy down along the IS curve. equilibrium level of income also changes in accordance with the simple would call it “unemployment equilibrium.” Note that the interest rate, which continues to match the money supply to the Keynesian multiplier. speculative demand for money, remains unchanged. ISLM Analysis Part II: The Monetary Sector (The Hard-Drawn Keynesian View) The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2010