the quantity theory and the keynesian theory of money
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The Quantity Theory and the The Quantity Theory and the Keynesian Theory of MoneyKeynesian Theory of Money
Classical analysis of prices and inflationClassical analysis of prices and inflation
This model gives an introduction to equilibrium in the money market
It further highlights important theoretical controversies between different schools of thought in economics Keynesians Monetarists
This model gives an introduction to equilibrium in the money market
It further highlights important theoretical controversies between different schools of thought in economics Keynesians Monetarists
Milton FriedmanMilton Friedman
The Quantity TheoryThe Quantity Theory
The quantity theory is by definition correct
MV = PY M = money supply V = velocity of circulation P = price level Y = national income
The quantity theory is by definition correct
MV = PY M = money supply V = velocity of circulation P = price level Y = national income
Money and the price levelMoney and the price level
Since MV = PY, it must be that P = MV/Y
Y is given like Yf (flexible prices), V is constant. Therefore, Change in M = change in P ”Inflation is anywhere and everywhere a
monetary phenomenon”
Since MV = PY, it must be that P = MV/Y
Y is given like Yf (flexible prices), V is constant. Therefore, Change in M = change in P ”Inflation is anywhere and everywhere a
monetary phenomenon”
AD2
AD1
O
AS
P1
Pric
e le
vel
National output
P2
Q1
The effect of printing extra money: the classical analysisThe effect of printing extra money: the classical analysis
Money and prices in Norway 1900-2000Money and prices in Norway 1900-2000
-20
-10
0
10
20
30
40
50
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990
MoneyCPI
-20
-10
0
10
20
30
40
50
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990
MoneyCPI
Money and Interest RatesMoney and Interest Rates
The Demand for MoneyThe Demand for Money
Keynesian money demandKeynesian money demand
Why do we need money: Transaction purposes Precautionary purposes Safety purposes
Money demand is above all dependent on: income (+) interest rates (-)
Why do we need money: Transaction purposes Precautionary purposes Safety purposes
Money demand is above all dependent on: income (+) interest rates (-)
THE DEMAND FOR MONEYTHE DEMAND FOR MONEY
The motives for holding money: liquidity preference
transactions and precautionary demand for money: L1
The motives for holding money: liquidity preference
transactions and precautionary demand for money: L1
The transactions-plus-precautionary demand for money: L1The transactions-plus-precautionary demand for money: L1
O
Ra
te o
f in
tere
st
L1
Active balances
THE DEMAND FOR MONEYTHE DEMAND FOR MONEY
The motives for holding money: liquidity preference
transactions and precautionary demand for money: L1
speculative demand for money: L2
The motives for holding money: liquidity preference
transactions and precautionary demand for money: L1
speculative demand for money: L2
The speculative demand for money: L2The speculative demand for money: L2
O
Ra
te o
f in
tere
st
L2
Idle balances
THE DEMAND FOR MONEYTHE DEMAND FOR MONEY
The motives for holding money: liquidity preference
transactions and precautionary demand for money: L1
speculative demand for money: L2
the total demand for money: L1 + L2
The motives for holding money: liquidity preference
transactions and precautionary demand for money: L1
speculative demand for money: L2
the total demand for money: L1 + L2
The total demand-for-money curve: L (= L1 + L2)The total demand-for-money curve: L (= L1 + L2)
O
Ra
te o
f in
tere
st
Total money balances
L ( = L1 + L2)
L2
L1
Money and Interest RatesMoney and Interest Rates
Equilibrium in the Money Market
Equilibrium in the Money Market
The supply of money curve: (a) exogenous money supplyThe supply of money curve: (a) exogenous money supply
O
Ra
te o
f in
tere
st
Quantity of money
MS
Equilibrium in the money marketEquilibrium in the money market
O
Ra
te o
f in
tere
st
L
Money
MS
re
Me
O
Ra
te o
f in
tere
st
L
Money
MS
re
Me
Equilibrium in the money marketEquilibrium in the money market
Relationship between theRelationship between theMoney and Goods MarketsMoney and Goods Markets
Relationship between the Money and Goods Markets
Relationship between the Money and Goods Markets
Effects of Monetary Changes on National
Income
Effects of Monetary Changes on National
Income
I
O O
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
MS
L
r1
Money InvestmentI1
r1
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
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
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
Effect of a rise in money supply:the traditional Keynesian transmission mechanism
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
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
r1
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
r1
Investment Investment
I
I
I1 I1
r2
I2
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
r1
Ra
te o
f in
tere
st
Ra
te o
f in
tere
st
r1
Investment Investment
I
I
I1 I1
r2 r2
I2 I2
Different views on the demand for investmentDifferent views on the demand for investment
Relationship between the Money and Goods Markets
Relationship between the Money and Goods Markets
ISLM AnalysisISLM Analysis
Sir John Hicks (1904 – 1989)Sir John Hicks (1904 – 1989)
Inje
ctio
ns,
With
dra
wa
ls
OI1
S1R
ate
of i
nte
rest
O
r1
Assume that an interestrate of r1 gives investment
of I1 and saving of S1
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
ls
OI1
S1
Assume that an interestrate of r1 gives investment
of I1 and saving of S1
Y1
Ra
te o
f in
tere
st
O
r1
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1
S1
Assume that an interestrate of r1 gives investment
of I1 and saving of S1
Y1
Y1
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1
S1
Assume that an interestrate of r1 gives investment
of I1 and saving of S1
Y1
Y1
a
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1
S1
Now assume that the interestrate falls to r2, giving
investment of I2 and saving of S2
Y1
Y1
I2
S2
Y2
r2
a
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1
S1
Now assume that the interestrate falls to r2, giving
investment of I2 and saving of S2
Y1
Y1
I2
S2
Y2
r2
a
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1
S1
Y1
Y1
I2
S2
Y2
r2
a
b
Now assume that the interestrate falls to r2, giving
investment of I2 and saving of S2
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1
S1
Now assume that the interestrate falls to r2, giving
investment of I2 and saving of S2
Y1
Y1
I2
S2
Y2
r2
IS
b
a
Goods market equilibrium: deriving the IS curveGoods market equilibrium: deriving the IS curve
The IS curveThe IS curve
Inje
ctio
ns,
With
dra
wa
lsR
ate
of i
nte
rest
O
O
r1
I1
S1
Y1
Y1
I2
S2
Y2
r2
IS
b
a
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
Money National income
Y1
MS
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
Money National income
Y1
MS
r1 r1
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
Money National income
Y1
MS
r1 r1
L'
c
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
Money National income
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"
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
Money National income
Y1
MS
r1 r1
r2 r2
Y2
L"L'
c
Now assume that at the higher level of national income, Y2,
the demand for money rises to 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
Money National income
Y1
MS
r1 r1
r2 r2
Y2
L"L'
c
d
Now assume that at the higher level of national income, Y2,
the demand for money rises to 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
Money National income
Y1
LMMS
r1 r1
r2 r2
Y2
L"L'
c
d
Now assume that at the higher level of national income, Y2,
the demand for money rises to L"
Money market equilibrium: deriving the LM curveMoney market equilibrium: deriving the LM curve
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
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
r1
Y1
a
This gives a rate ofinterest of r1 (point a)
LM
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
r1
Y1 Y2
a
But at r1, national incomeis below the goods market
equilibrium level (Y2)
b
LM
Equilibrium in both the goods and money marketsEquilibrium in both the goods and money markets
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
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
re
Ye
LM
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
LM
IS
r1
Y1
ISLM analysis of changes in the goods and money markets
ISLM 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
ISLM analysis of changes in the goods and money markets
ISLM analysis of changes in the goods and money markets
O
Ra
te o
f in
tere
st
National income
LM1
IS
r1
Y1
LM2
r3
Y3
A rise in themoney supply
ISLM analysis of changes in the goods and money markets
ISLM analysis of changes in the goods and money markets
LM2LM1
O
Ra
te o
f in
tere
st
National income
IS1
r1
Y1
IS2
Y4
A rise in bothinjections andmoney supply
ISLM analysis of changes in the goods and money markets
ISLM analysis of changes in the goods and money markets
R
Y
LM
ISIS`
Liquidity trapLiquidity trap
The classical caseThe classical case
R
Y
LMIS
IS`