relationship between money and goods markets

Relationship between theRelationship between theMoney and Goods MarketsMoney and Goods Markets

Relationship between the Money and Goods MarketsRelationship between the Money and Goods Markets

Effects of Monetary Changes on

National Income

Effects of Monetary Changes on

National Income

MONEY AND NATIONAL INCOMEMONEY AND NATIONAL INCOME

• The quantity theory of money

– the quantity equation: MV = PY

– the stability of V

– the stability of Y

• Interest-rate transmission mechanism

– stage 1: money – interest rate link

– stage 2: interest rate – investment link

– stage 3: multiplier effect

• The quantity theory of money

– the quantity equation: MV = PY

– the stability of V

– the stability of Y

• Interest-rate transmission mechanism

– stage 1: money – interest rate link

– stage 2: interest rate – investment link

– stage 3: multiplier effect

r1

MS

L

Effect of a rise in money supply:the traditional Keynesian transmission mechanism


O

Ra

te o

f in

tere

st

Money

I

O O

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st

MS

L

r1

Money InvestmentI1

r1



Y1O

W

J1

(= I1 + G + X)



I2O O

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st

MS

L

r1 r1

I

Money InvestmentI1

MS'

r2 r2

(b) Stage 2: r I (b) Stage 2: r I (a) Stage 1: MSr (a) Stage 1: MSr



O

W

J1

(= I1 + G + X)

Y1

J2

(= I2 + G + X)

Y2

(c) Stage 3: I J Y (c) Stage 3: I J Y



• Limitations of the interest rate transmission mechanism

– possible problems with stage 1: money – interest rate link

• elastic demand for money





O

Ra

te o

f in

tere

st

Money

MS

Lr1

MS'

r2

MS"

An elastic liquidity preference curveAn elastic liquidity preference curve




• unstable demand for money






O

Money

Ra

te o

f in

tere

st

MS

L

r

L '

r1

The effect on interest rates of a fluctuating demand for moneyThe effect on interest rates of a fluctuating demand for money





– possible problems with stage 2: interest rate – investment link












• inelastic investment demand








O

(a) Keynesian(a) Keynesian

Ra

te o

f in

tere

st

Investment

I

I1

r1

Different views on the demand for investmentDifferent views on the demand for investment

O O

(a) Keynesian(a) Keynesian (b) New classical / Monetarist(b) New classical / Monetarist

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st

r1

Investment Investment

I

I

I1 I1

r1


O O


r1

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st

r1


I

I

I1 I1

r2

I2


O O


r1

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st

r1


I

I

I1 I1

r2 r2

I2 I2








• unstable investment demand







• unstable investment demand


O

I1

Q0

r0

Investment

Rat

e of

inte

rest

r1

Q1

The effects of interest rate changes, given an unstable investment demand curve


O

I1

Q0

r0

Investment

Rat

e of

inte

rest

r1

Q1

I2

Q2

The fall in interest rates isaccompanied by an increase

in business confidence



O

I1

Q0

r0

Investment

Rat

e of

inte

rest

r1

Q1

The fall in interest rates isaccompanied by a decrease

in business confidence

I3

Q3




• The exchange-rate transmission mechanism

– the stages

• money supply – interest rate link

• interest rate – exchange rate link

• exchange rate – import and export link


– the stages




MS

L

O

Ra

te o

f in

tere

st

r1

Money

The exchange rate transmission mechanismThe exchange rate transmission mechanism

O

D1

S1

O

Ra

te o

f in

tere

st

Exc

ha

nge

ra

te

MS

L

r1

Quantity of sterling

er1

Money


O O

M

D1

Exports (X), Imports (M)

er1

S1

X

er1

Exc

ha

nge

ra

te

M1X1


Exc

ha

nge

ra

te


W1 (= S + M1 + T)

J1 (= I + X1 + G)

O Y1

W, J

Y


O O

Ra

te o

f in

tere

st

Exc

ha

nge

ra

te

MS

L

r1

D1

Money Quantity of sterling

er1

S1MS'

r2

(a) Stage 1: MSr


O O

Ra

te o

f in

tere

st

MS

L

r1

D1

Money Quantity of sterling

er1

S1MS'

r2

(a) Stage 1: MSr (b) Stage 2: MSr er

D2

S2

er2

Exc

ha

nge

ra

te


O O

D1


er1

S1

(b) Stage 2: MSr er

D2

S2

er2

Exc

ha

nge

ra

te


O

D1


er1

S1

D2

S2

er2

(b) Stage 2: MSr er

O

M

X

Exports (X), Imports (M)

er1

Exc

ha

nge

ra

te

M1X1

(c) Stage 3: er M , X

er2

X2M2

Exc

ha

nge

ra

te


O Y1

(d) Stage 4: M , X Y

W1 (= S + M1 + T)

J1 (= I + X1 + G)

W2 (= S + M2 + T)

J2 (= I + X2 + G)

Y2

W, J

Y




– the stages




– the strength of the effect


– the stages







– the stages





– the variability of the effect


– the stages





– the variability of the effect

• Portfolio balance

– the theory of portfolio balance

– Keynesian criticisms

– portfolio balance and the interest-rate mechanism

• The stability of the velocity of circulation

– short-run variability of V

– long-run stability of V

• Portfolio balance

– the theory of portfolio balance

– Keynesian criticisms

– portfolio balance and the interest-rate mechanism

• The stability of the velocity of circulation

– short-run variability of V

– long-run stability of V


M0 and M4 velocities of circulationM0 and M4 velocities of circulationM

0 ve

loci

tyM

4 velocity

M0 velocity

10

15

20

25

30

35

1970 1975 1980 1985 1990 1995 2000

0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40


0 ve

loci

ty

M0 velocity

M4 velocity

10

15

20

25

30

35

1970 1975 1980 1985 1990 1995 2000

0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40


0 ve

loci

ty

M4 velocity

M4 velocity

M0 velocity

10

15

20

25

30

35

1970 1975 1980 1985 1990 1995 2000

0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40


Monetary Effects of Changes in the Goods Market

Monetary Effects of Changes in the Goods Market

MONETARY EFFECTS OF GOODS MARKET CHANGESMONETARY EFFECTS OF GOODS MARKET CHANGES

• Monetary effects of changes in aggregate demand

– effect on interest rates

– effect on national income

• Monetary effects of changes in aggregate demand

– effect on interest rates

– effect on national income

O

W, J

Y

(a) The goods market(a) The goods market

W

J1

Y1

The monetary effects of a rise in injectionsThe monetary effects of a rise in injections

O O

W, JRate of interest

Y Money

(a) The goods market(a) The goods market (b) The money market(b) The money market

W

J1

Y1

MS

L1

r1


O O


Y Money


W

J1

Y1

MS

L1

r1

Y2

J2

An expansionaryfiscal policy


O O


Y Money


W

J1

Y1

MS

L1

r1

Y2

J2


L2

r2

Effect on thedemand for money


O O


Y Money


W

J1

Y1

MS

L1

r1

Y2

J2


L2

Accommodatingincrease in themoney supply

MS2

r2



• Crowding out– the analysis of crowding out

– the extent of crowding out• responsiveness of demand for money to an

interest rate change

• responsiveness of investment to an interest rate change

– analysis under Keynesian and monetarist assumptions






Different views on the demand for moneyDifferent views on the demand for money

O

MS

Lr1

Ra

te o

f in

tere

st

Money


O O

MS

Lr1

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st

MS

r1

L

Money Money


(a) Keynesian (b) New classical / Monetarist(b) New classical / Monetarist

O O

MS

Lr1

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st

MS

r1

L'r2

L

Money Money


(a) Keynesian(a) Keynesian (b) New classical / Monetarist

O O

MS

Lr1

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st

MS

L

r1

L'r2

r2

L'

Money Money




O


Ra

te o

f in

tere

st

Investment

I

I1

r1

O O


Ra

te o

f in

tere

st

Ra

te o

f in

tere

st

r1


I

I

I1 I1

r1


O O

(a) Keynesian(a) Keynesian (b) New classical / Monetarist

r1

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st

r1


I

I

I1 I1

r2

I2


O O


r1

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st

r1


I

I

I1 I1

r2 r2

I2 I2








• Money supply: exogenous or endogenous?






• Money supply: exogenous or endogenous?


ISLM AnalysisISLM Analysis

ISLM ANALYSISISLM ANALYSIS

• The goods and money markets

• The IS curve– deriving the IS curve



Inje

ctio

ns,

With

dra

wa

ls

OI1 (J1)

S1 (W1)R

ate

of i

nte

rest

O

r1

Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve

Assume that an interestrate of r1 gives investment

of I1 and saving of S1

Inje

ctio

ns,

With

dra

wa

ls

OI1 (J1)

S1 (W1)



Y1

Ra

te o

f in

tere

st

O

r1


Inje

ctio

ns,

With

dra

wa

lsR

ate

of i

nte

rest

O

O

r1

I1 (J1)

S1 (W1)



Y1

Y1


Inje

ctio

ns,

With

dra

wa

lsR

ate

of i

nte

rest

O

O

r1

I1 (J1)

S1 (W1)



Y1

Y1

a


Inje

ctio

ns,

With

dra

wa

lsR

ate

of i

nte

rest

O

O

r1

I1 (J1)

S1 (W1)

Now assume that the interestrate falls to r2, giving

investment of I2 and saving of S2

Y1

Y1

I2 (J2)

S2 (W2)

Y2

r2

a


Inje

ctio

ns,

With

dra

wa

lsR

ate

of i

nte

rest

O

O

r1

I1 (J1)

S1 (W1)

Y1

Y1

I2 (J2)

S2 (W2)

Y2

r2

a

b




Inje

ctio

ns,

With

dra

wa

lsR

ate

of i

nte

rest

O

O

r1

I1 (J1)

S1 (W1)



Y1

Y1

I2 (J2)

S2 (W2)

Y2

r2

IS(J = W)

b

a





– elasticity of the IS curve




The IS curveThe IS curve

Inje

ctio

ns,

With

dra

wa

lsR

ate

of i

nte

rest

O

O

r1

I1 (J1)

S1 (W1)

Y1

Y1

I2 (J2)

S2 (W2)

Y2

r2

IS(J = W)

b

a





– shifts in the IS curve





The IS curveThe IS curve

Inje

ctio

ns,

With

dra

wa

lsR

ate

of i

nte

rest

O

O

r1

I1 (J1)

S1 (W1)

Y1

Y1

I2 (J2)

S2 (W2)

Y2

r2

IS(J = W)

b

a






• The LM curve





• The LM curve






• The LM curve– deriving the LM curve






O O

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st

Money National income

Y1

L'

Assume that at a level ofnational income, Y1,

the demand for money is L'

Money market equilibrium: deriving the LM curveMoney market equilibrium: deriving the LM curve

O O

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st


Y1

MS

L'




O O

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st


Y1

MS

r1 r1

L'




O O

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st


Y1

MS

r1 r1

L'

c




O O

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st


Y1

MS

r1 r1

Y2

L"L'

c

Now assume that at the higher level of national income, Y2,

the demand for money rises to L"


O O

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st


Y1

MS

r1 r1

r2 r2

Y2

L"L'

c




O O

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st


Y1

MS

r1 r1

r2 r2

Y2

L"L'

c

d




O O

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st


Y1

LMMS

r1 r1

r2 r2

Y2

L"L'

c

d










– elasticity of the LM curve







O O

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st


Y1

LMMS

r1 r1

r2 r2

Y2

L"L'

c

d

The LM curveThe LM curve








– shifts in the LM curve








O O

Ra

te o

f in

tere

st

Ra

te o

f in

tere

st


Y1

LMMS

r1 r1

r2 r2

Y2

L"L'

c

d

The LM curveThe LM curve









• Equilibrium in the model








• Equilibrium in the model

O

Ra

te o

f in

tere

st

National income

LM

IS

Equilibrium in both the goods and money marketsEquilibrium in both the goods and money markets

O

Ra

te o

f in

tere

st

National income

IS

Y1

a

Assume that national incomeis currently at a level of Y1

LM


O

Ra

te o

f in

tere

st

National income

IS

r1

Y1

a

This gives a rate ofinterest of r1 (point a)

LM


O

Ra

te o

f in

tere

st

National income

IS

r1

Y1 Y2

a

But at r1, national incomeis below the goods market

equilibrium level (Y2)

b

LM


But as income rises, so therewill be a movement up theLM curve. The interest ratewill rise, thereby reducingnational income below Y2.

O

Ra

te o

f in

tere

st

National income

IS

r1

Y1 Y2

a b

LM


O

Ra

te o

f in

tere

st

National income

IS

re

Ye

LM



• Full effects of changes in the goods and money markets

– effects of changes in the goods market



O

Ra

te o

f in

tere

st

National income

LM

IS

r1

Y1

ISLM analysis of changes in the goods and money marketsISLM analysis of changes in the goods and money markets

O

Ra

te o

f in

tere

st

National income

IS1

r1

Y1

IS2

r2

Y2

A rise ininjections

LM





– effects of changes in the money market




O

Ra

te o

f in

tere

st

National income

LM1

IS

r1

Y1

LM2

r3

Y3

A rise in themoney supply






– effects of changes in both markets





LM2LM1

O

Ra

te o

f in

tere

st

National income

IS1

r1

Y1

IS2

Y4

A rise in bothinjections andmoney supply







• Deriving an AD curve from the ISLM model





• Deriving an AD curve from the ISLM model

Rat

e of

inte

rest

(r)

Pric

e le

vel (

P)

National income (Y)

National income (Y)

LM1

IS

Y1

r1

P1

Deriving the AD curve from an ISLM diagramDeriving the AD curve from an ISLM diagram

Y1

a'

a

Rat

e of

inte

rest

(r)

Pric

e le

vel (

P)

National income (Y)

LM1LM2

IS

AD

Y1

Y1Y2

r2

r1

P2

P1

Deriving the AD curve from an ISLM diagramDeriving the AD curve from an ISLM diagram

a'

a

Y2

b'

b

National income (Y)


Taking Inflation into Account

Taking Inflation into Account

TAKING INFLATION INTO ACCOUNTTAKING INFLATION INTO ACCOUNT

• The policy of inflation targeting

• AD and AS plotted against inflation

– the inflation target line




O

National income

Rat

e of

infla

tion

(P).

Ptarget

.

The inflation target lineThe inflation target line





– the ADI curve




– the ADI curve

O

National income

ADI

Rat

e of

infla

tion

(P).

Ptarget

.

AD plotted against inflationAD plotted against inflation

Y1

the ADI curve

• why downward sloping?

• what determines the slope?

• movements along and shifts in the ADI curve

the ADI curve








– the ADI curve




– the ASI curve




– the ADI curve




– the ASI curve

O

ASI

Y1

National income

ADI1

Rat

e of

infla

tion

(P).

Ptarget

. a

AD and AS plotted against inflationAD and AS plotted against inflation


• Response to change in aggregate demand and supply

– a change in aggregate demand



O

ASI

Y1

National income

ADI1

Rat

e of

infla

tion

(P).

Ptarget

.

ADI2

Y2

P2

.a

b


Y3

c

O

ASI

Y1

National income

ADI1

Rat

e of

infla

tion

(P).

Ptarget

.

ADI2

Y2

P2

.a

b





– a change in aggregate supply








• a temporary supply shock





O

ASI1

National incomeY1

ADI1

Rat

e of

infla

tion

(P).

Ptarget

.

Y2

P2

.a

ASI2

b

The effects of a increase in aggregate supply(a) a temporary increase in aggregate supply

The effects of a increase in aggregate supply(a) a temporary increase in aggregate supply






• a permanent change in aggregate supply





• a permanent change in aggregate supply

O

ASI1

Y1

National income

ADI1

The effects of a increase in aggregate supply(b) a permanent increase in aggregate supply

The effects of a increase in aggregate supply(b) a permanent increase in aggregate supply

Rat

e of

infla

tion

(P).

Ptarget

.

Y2

P2

.a

ASI2

b

ADI2

Y3

c

Central bank cutstarget interest rate

relationship between money and goods markets

Documents