Lecture VI Flashcards
Assumes the Keynesian Model.
What is the Keynes Theory of the Interest Rate?
Keynes hypothesised that wealth (Wh) could be divided into holdings of bonds (B)
and money (M).
Wh = B + M
The equilibrium interest rate is the rate where the demand and supply of bonds are
equal. This implies that the bond market is in equilibrium—since the person is satisfied with how much he is holding in bonds at the current rate of interest, there is no excess supply of or demand for bonds.
What were Keynes’s three motives for money demand?
Keynes identified three motives for money demand: transactions, precautionary, and speculative. Transactions demand relates to the ease of converting money into goods without incurring transaction costs. Precautionary demand arises from the need for a financial buffer against unexpected events. Speculative demand is unique, driven by fluctuations in bond prices due to interest rate changes. Keynes theorized that people anticipate normal interest rates and adjust bond investments accordingly. Above the normal rate, bondholders expect gains; below it, losses. Between the normal and critical values, interest payments prevail.
Briefly describe changes in the liquidity preference model.
Assuming a fixed money supply, equilibrium in the money market determines the interest rate. Money demand and supply intersection establish this equilibrium. Income (Y) remains constant in deriving the demand curve; changes in Y shift the curve and affect interest rates in a procyclical manner. Monetary policy shifts the curve: expansion lowers interest rates, while contraction raises them. The relationship between the money market and the goods market is demonstrated by the IS/LM model, which combines the Keynesian model with liquidity preference. The IS/LM model assumes firms supply output demanded at a fixed price.
Primary features of the IS/LM Model.
The IS/LM model is a demand-side model;
both the simple Keynesian model and liquidity preference model are AD-side concepts. The IS/LM model thus assumes that firms automatically supply whatever level of output is demanded at a fixed price (essentially, a horizontal AS curve whereby AD determines Y*).
