Transcript ISLM: Part II: The Monetary Sector

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
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And he gets $30 biannually for 30 years.
$30
$30
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He can sell the bond any time he wants.
$30
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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
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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