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ISLM Analysis Part III: The Monetary Sector (with MV=PQ in play) The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2010 S S Seq i ieq i MS MS MSPEC ieq Y I i IS Yeq Y Ieq I Keynes’s But Keynes hard-drawn did recognize version another of thecomponent monetary sector of the gives demand no play for money. to the The equation transactions of exchange. demand for Themoney whole(M story is—or about simply the supply MT) depends of money primarily TRANS and on income the speculative and not so demand much for on money. the interest The rate. interest It israte, this which component (MT) balances supply against demand is aequation purely monetary phenomenon. that can be analyzed in terms of the of exchange. Y/P = Q (MV)0 P MT So, how is MT graphed as a function of Y? Y = PQ The classical economists wrote: Keynes recognized that the transactions velocity of money, like the velocity of money in the classical formulation, is fairly stable. VT is more or less constant. MV = PQ, where Q also represents real income—i.e., Q = Y/P. Since Q = Y/P, then PQ = Y. So, we can write MV = Y, which applies, Keynes insisted, only to the transactions demand for money. This means that MT is linearly related to Y. MT = Y/ VT graphs as a straight line that emanates from the origin and has a slope of 1/VT. And so, MTVT = Y or MT = Y/VT MT 1 VT Y Y/P = Q (MV)0 P MT So, how is MT1 graphed as V a function of Y? T Y = PQ MT is one component of the demand for money. The other component is MSPEC. The monetary sector is in equilibrium when money Keynes took the two components to be additive. supply equals money That is, the total demand for money (MD) is equal demand. to MSPEC plus MT. [Or simply: MD = MSPEC + MT] Simply written: MS = MD. i So, MS = MSPEC + MT, where MS is controlled by the central bank. MSPEC MT This equilibrium condition graphs as a straight line with a vertical intercept of MS, a horizontal intercept of MS and a slope of negative one. MT 1 MS VT 1 1 S MSPEC Y The supply is managed by thefor central MT ismoney one component of the demand money. bank, i.e, the Federal Reserve. The other component is MSPEC. So, the Fed can increase or decrease MS, as deemed necessary. Keynes took the two components to be additive. As thethe case the hard-drawn version D) of Thatin is, totalofdemand for money (M is equal S Keynes’s model, in M to MSPEC plus MT.changes [Or simply: MD can = Minfluence SPEC + MT] both income and the interest rate. i MT MSPEC Simply written: MS = MD. So, MS = MSPEC + MT, where MS is controlled by the central bank. This equilibrium condition graphs as a straight line with a vertical intercept of MS, a horizontal intercept of MS and a slope of negative one. MT 1 VT MSPEC The monetary sector is in equilibrium when money supply equals money demand. Y The two (additive) demands for money together with the equilibrium condition imply possible combinations of income and the interest rate that are consistent with equilibrium in the monetary sector. i MT i MSPEC MSPEC MT LM Y Y The line connecting the possible equilibrium points is called the LM curve—with L (liquidity) representing the demand for money and M representing money supply. The two (additive) demands for money together with the equilibrium condition imply possible combinations of income and the interest rate that are consistent with equilibrium in the monetary sector. i MT i MSPEC MSPEC MT LM Y Y The line connecting the possible equilibrium points is called the LM curve—with L (liquidity) representing the demand for money and M representing money supply. S The Keynesian Framework According to John Hicks and Alvin Hansen S Seq W S i i ieq ieq MT MSPEC MT Y LM i LABOR INCOME D I N IS Yeq Y Ieq I This is the Hicks-Hansen, fixed-price, eight-quadrant diagrammatical exposition of Keynesian Macroeconomics. MSPEC Y S The Keynesian Framework According to John Hicks and Alvin Hansen Seq i i ieq ieq MT MSPEC S MT Y LM i IS Yeq Y Ieq I The “animal speculative spirits” demand that govern for money, investment which reflects the demand can“fetish wax and of liquidity” wane, causing is similarly unstable. movements amplified A strengthening in theorISweakening curve. of the fetishspirits Waxing generates can result a mirror-image in inflation; waning spirits can result movement of the inLMunemployment. curve. Watch. MSPEC I Y S The Keynesian Framework According to John Hicks and Alvin Hansen Seq i i ieq ieq MT MSPEC S MT Y LM i IS Yeq Y Ieq I “Animal spirits” and the “fetish of liquidity” can interact, setting both the IS curve and the LM curve in motion. Fine tuning such a macroeconomy with fiscal and monetary policy is the ultimate “mission incredible.” Watch. MSPEC I Y S The Keynesian Framework According to John Hicks and Alvin Hansen S Seq i i ieq ieq Y LM I i IS MT MSPEC MSPEC MT Yfe Y Ieq I Even without “animal spirits” and the “fetish of liquidity,” monetary policy may not be able to lift the economy out of recession. The obstacles come in the form of the “Liquidity Trap” and the “Stagnation Thesis.” Y ISLM Analysis Part III: The Monetary Sector (with MV=PQ in play) The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2010