Download r I

The money supply
(MS) is assumed to be an
autonomous variable-that is, MS is under the
control of the FED.
MS
MS’
MS  MS’ due to:
•Open market
purchase by the FED.
•Decrease in rr.
•Decrease in the
discount rate
Money supply
(MS)
Demand for Money (DM) in the Keynesian System
The Keynesian demand for money (DM) (or
“liquidity preference”) function can be
expressed by:
DM = f (r, Y), where:
• DM /r < 0  demand for money is
inversely related to the interest rate, ceteris
paribus.
•DM /Y > 0  demand for money is
positively relation to real income (GDP),
ceteris paribus.
A change in the demand for money (DM)
   due to:
r
10



7
•Decrease in r, ceteris
paribus
   due to:
D2M
•increase in Y, ceteris
paribus.
D1 M
90
120
•Market bearishness
DM
r
MS
 The equilibrium
interest rate satisfies the
condition:
DM = MS
8
DM
120
MD, MS
Keynesian view of the transmission mechanism
 The term “monetary
transmission
mechanism” means the
channels through which
changes in monetary
policy (or the money
supply) are
“transmitted” to
important macroecomic
variables such as real
GDP, employment, and
prices.
In Keynesian theory,
monetary policy is
transmitted to aggregate
demand via the interest
rate-investment linkage
Expansionary monetary policy: The Keynesian interpretation
r
MS
MS’
AE = Y
AE
AE2
9
AE1
DM
7
MS, DM
r
725
700
9
2,100
7
100 125
I
2,175
Y
1
Y  I 
 (25)(3)  $75
1 c  m
Why monetary policy may be ineffective
Not interest-sensitive
r
The FED may be
successful in decreasing
interest rates. But what if
investment spending fails to
respond?
9
7
I2
I1
70 74
95
I
Why monetary policy may be ineffective, part 2
r
MS
3
MS’
At an interest rate of
3% or below, wealth
holders prefer money to
bonds, equities, etc.
Hence DM is horizontal
at an interest rate
of 3 %
DM
DM, MS
MS leaves r unchanged; hence, no effect on I, Y, or employment.
The FED’s contractionary regime has been
ineffective so far
r
MS’
r
MS
8.25
8.25
7.5
7.5
DM
I1
0
0
A
I2
I
B
Effect of rising mortgage interest rates on monthly mortgage
payments
Amount
Borrowed
Term
Interest
Rate
Monthly
Payment
$100,000
30 years
7.5%
$699.21
100,000
30 years
8.25%
$751.27