22.3 Aggregate Demand Curve #Notebook
The AD curve is essentially just another way of stating the IS-LM model, anything that would change the IS or LM curves will also shift the AD curve.
The AD curve shifts in the same direction as the IS curve and the AD curve also shifts in the same direction as the LM curve.
Reference
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.
22.2 Implications for Monetary Policy #Notebook
The IS-LM model has a major implication for monetary policy. When the IS curve is unstable, a money supply target will lead to greater output stability, and when the LM curve is unstable, an interest rate target will produce greater macro stability.
The policy power of the IS-LM is severely limited by its short-run assumption that the price level doesn’t change.
The key is the addition of a new concept, called the natural rate level of output, Ynrl, the rate of output at which the price level is stable in the long run.
When actual output (Y*) is below the natural rate, prices will fall; when it is above the natural rate, prices will rise.
The IS curve is stated in real terms because it represents equilibrium in the goods market, therefore changes in the price level do not affect consumption expenditures, investment, government spending, Taxes, or net exports or the IS curve.
However, the LM curve is affected by changes in the price level, shifting to the left when prices rise and to the right when they fall.
Holding the nominal MS constant, rising prices decrease real money balances, shifts the LM curve to the left.
Suppose an economy is in equilibrium at the natural rate level of output (Ynrl), when the monetary stimulus increase the MS shifts the LM curve to the right. In the short term, interest rates will come down and output will increase. But because actual output Y* is greater than Ynrl, prices will rise, shifting the LM curve back. As a result, the output and the interest rate are the same but prices are higher. Economists call this long-run monetary neutrality.
Fiscal stimulus shifts the IS curve to the right, increasing output but also the interest rate. Because Y* is greater than Ynrl, prices will rise and the LM curve will shift left, reducing output, increasing the interest rate higher still, and raising the price level.
Under the IS-LM Model, looks like policymakers just can’t win in the long run, since policymakers cannot make Y* exceed Ynrl.
Reference
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.
21.1 Aggregate Output and Keynesian Cross Diagrams #Notebook
Developed in 1937 by economist and Keynes disciple John Hicks, the IS-LM model is still used today to model aggregate output (GDP, or GNP) and interest rates in the short run. It begins with John Maynard Keynes’s recognition that
AoS = AD = Cs + Inv + Gs + NExpo
Aggregate output (Supply) = Aggregate demand = Consumer expenditure + Investment + Governemnt spending + Net exports
Keynes further explained that Consumer expenditure can be calculated by:
Consumer expenditure = Autonomous consumer expenditure (food, clothing, shelter, and necessaries) + ( Marginal propensity to consume X Disposable income )
For example, during the Great Depression, the investment fell from $232 billion to $38 billion (in 2000 USD), so the aggregate output fell by more than $232 billion − $38 billion = $194 billion.
We know that because investment fell and the marginal propensity to consume was > 0, so, the fall was more than $194 billion.
An increase in exports over imports will increase aggregate output by the increase in NExpo times the expenditure multiplier. Likewise, a decrease in NExpo will decrease aggregate output by the decrease in NExpo times the multiplier.
Government spending (Gs) also increases aggregate output. However, some government spending comes from taxes, which consumers view as a reduction in income. With taxation, the consumption must to minus the taxations.
Many governments, including that of the United States, responded to the Great Depression by increasing tariffs. Today we know that such policies beggared everyone. What were policymakers thinking?
They were thinking that tariffs would decrease imports and thereby increase NExpo and aggregate output. That would make their trading partner’s NExpo decrease, thus beggaring them by decreasing their aggregate output.
But, in reality, it was dead wrong. Other countries retaliated with tariffs of their own. Even if they did not do it, it was a losing strategy because by making trading partners poorer.
In short, the policy limited their own ability to import and led to no long-term change in NExpo.
Reference
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.
Assume that we have the following data:
C=100+0.50Y
Ip=100-20r
Mt=0.10Y
Ms=100-10r
M=80
a. Build the IS-LM function
Suppose the government spending, and the net export(NExpo) is o, then the model will be:
IS Model:
Y = Aggregate demand = Consumer and household consumption expenditures + Investment + Government spending + NExpo
Y = (100 + 0.5Y) + (100 - 20r) = 200 +0.5Y -20r
0.5Y = 200 - 20r
Y = 400 - 40r (The IS Equation)
The LM Model:
Money demand (speculative, transaction demand) is equal to the Money supply.
Money demand = Money supply
100 - 10r + 0.1Y = 80
0.1Y = 10r - 20
Y = 100r - 200 (The LM Equation)
The IS & LM intersection
400 - 40r = 100r - 200
140r = 600
r = 4.29
Y = 100r - 200
Y = (100 * 4.29) - 200
Y = 429 - 200
Y = 229
The intersection is (229, 4.29), which means the equilibrium interest rate 4.29% and the eqiilibrium output 229.
b. If we assume an increase in Investments by 100 units, please calculate again the IS-LM functions.
Assume an increase in Investments by 100 units, then....
The original IS Equation = Y = 400 - 40r
The new IS Equation = Y = 400 - 40r +100 = 500 - 40r
Y = 500 - 40r
For every given data, the IS Equation will shift rightward (+100), and cause the equilibrium to have a larger aggregate output and larger interest rate which will also increase the supply of goods.
c. The intersection of IS-LM functions defines four areas. Please analyze the behavior of the markets for goods and money for each area.
Normally, there are four areas on the graph, separate by the equilibrium point of the intersection of the LM Equation line and the IS Equation line.
Region AB represents the pressure on the interest rate to fall down since it's higher than the theoretical equilibrium interest rate. As the interest rate goes down, the IS or LM curve respectively moving by their causes.
Region CD represents the pressure on the interest rate to increase since it's lower than the theoretical equilibrium interest rate. As the interest rate goes up, the IS or LM curve respectively moving by their causes.
Region BC represents the pressure on the output and supply to fall down since it's higher or lower than the theoretical equilibrium output and demand.
Region AD represents the pressure on the output and supply to increase since it's lower than the theoretical equilibrium output and demand.
Reference
Wright, R. E., & Quadrini, V. (2009).Money and Banking. Flat World Knowledge Inc.
22.1 Shifting The IS-LM Curves #Notebook
The IS-LM model can help policymakers to decide between two major types of policies such as government expenditure and tax, or monetary (interest rates and money supply).
An autonomous expenditure describes the components of an economy's aggregate expenditure that are not impacted by the level of income. This type of spending is considered automatic and necessary.
The classical economic theory states that any rise in autonomous expenditures will create at least an equivalent rise in aggregate output, such as GDP, if not a greater increase.
The LM curve, the equilibrium points in the market for money, shifts for two reasons: changes in money demand, and changes in the money supply.
If the money supply increases (decreases), ceteris paribus, the interest rate is lower (higher) at each level of aggregate output.
The LM curve shifts right (left), means at any given level of output Y, more money (less money) means a lower (higher) interest rate.
An autonomous change in money demand (not related to the price level, aggregate output, or i) will also affect the LM curve such as stocks get riskier or the transaction costs of trading bonds increases.
The theory of asset demand tells us that the demand for money will increase (shift right), thus increasing interest rates.
Interest rates could also decrease if money demand shifted left because stock returns increased or bonds became less risky.
An increase in autonomous money demand will shift the LM curve left, with higher interest rates at each Y; a decrease will shift it right, with lower interest rates at each Y.
The IS curve shifts whenever an autonomous change occurs in Consumer spending, Investment, Government spending, Net exports.
The IS curve shifts right (left). When taxes increases (decreases), all else constant, the IS curve shifts left (right) because taxes effectively decrease consumption.
These are changes that are not related to output or interest rates, which merely indicate movements along the IS curve.
Changes in consumer preferences will change the output at each interest rate and shift the entire IS curve.
How Government Policies Can Affect Output?
In the short run, an increase in the money supply will shift the LM curve to the right, thereby lowering interest rates and increasing output. Decreasing the MS would have precisely the opposite effect.
Fiscal stimulus such as decreasing taxes or increasing government expenditures will also increase output but, unlike monetary stimulus (increasing MS), will increase the interest rate. This way, it works by shifting the IS curve upward rather than shifting the LM curve.
Since Y = Aggregate demand = Consumer and household consumption expenditures + Investment + Government spending + NExpo -Taxes. If taxes increases, the IS curve will shift left, decreasing interest rates but also aggregate output.
During financial panics, people often complain of high interest rates and declining economic output. Use the IS-LM model to describe why panics have those effects?
The LM curve will shift left during financial panics, raising interest rates and decreasing output, because the demand for money increases as economic agents scramble to get liquid.
During financial panics, the LM curve shifts left as people flee risky assets for money, thereby inducing the interest rate to climb and output to fall. Hamilton and Bagehot argued that monetary authorities should respond by increasing MS directly, shifting the LM curve back.
The LM curve shifts right (left) when the money supply, or demand (real money balances) increases (decreases).
The IS curve shifts right (left) when Consumption expenditures, Investment, Government, or Net exports increase (decrease), or Taxes decreases (increases). This relates directly to the Keynesian cross diagrams.
Reference
Wright, R. E., & Quadrini, V. (2009).Money and Banking. Flat World Knowledge Inc.
The Modern Quantity Theory and The Liquidity Preference Theory
Introduction
In every academic field, there are always better and better theories to help us better understand how the real world works. However, we can only close to be perfect, not actually perfect. The liquidity preference theory or the modern quantity theory all just trying to be perfect by thinking more and more deeply or more comprehensively. To figure out the pros and cons can help us learn from those mistakes and try to built a better world.
The Liquidity Preference Theory
The liquidity preference theory was developed by John Maynard Keynes, which assumes investors prefer cash or other highly liquid holdings while all other factors being equal. So, investors should demand a higher interest rate or higher return on securities that carry greater risk.
According to this theory, cash is a commonly accepted and most liquid asset. The interest rates on short-term securities are lower because investors are sacrificing less liquidity for the opportunity cost of time. John Maynard Keynes also mentioned three motives that determine the demand for liquidity, the transactions motive, precautionary motive, and speculative motive.
The transactions motive is part of our day to day life, higher costs of living such as more expensive to feed your stomach mean a higher demand for cash and liquidity to meet those basic needs. More than that, if investors invest their funds in stocks or any other securities, may also have a high demand for liquidity to repay their obligations, paying rents, or mortgages.
The concept of precautionary motive is similar to insurance, a preference for additional liquidity in some unexpected events may require a substantial outflow of cash, such as car repairs or healthcare bills.
The speculative motive is a little similar to the precautionary motive since we all have some concerns about the future. But unlike the precautionary motive that sources from what we need, the speculative motive sources from what we want. For example, when interest rates are low, the demand for cash is high and they may prefer to hold other assets until interest rates rise. What we want is a better opportunity in the future.
If a 3-year IOU is expected to get 3% in return, then a 10-year IOU is less likely to get 2% in return. For the investor to sacrifice liquidity, they must receive a higher rate of return in exchange to have the cash tied up for a longer period.
In conclusion, the liquidity preference theory refers to money demand as measured through liquidity. In real-world terms, the more quickly an asset can be converted into currency, the more liquid it becomes.
The Modern Quantity Theory
Unlike the liquidity preference theory, Friedman’s modern quantity theory predicts that interest rate changes should have little effect on money demand. Instead, the demand for money should depend not only on the risk and return offered by money but also on the various assets which the households can hold instead of money.
In short, transfers of stock or public debt are there equivalent to payments in species. So, velocity rises when there are money substitutes, highly liquid assets that allow economic agents to earn interest.
Why?
Because Friedman believed that the return on bonds, stocks, goods, and money would be positively correlated, leading to little change in the comparison of expected returns, such as the differences between bonds, stocks, or even inflations.
Reference
Chen, J. (2020, September 16). Liquidity Preference Theory Definition. Retrieved October 18, 2020, from https://www.investopedia.com/terms/l/liquiditypreference.asp
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.
20.3 Friedman versus Keynes #Notebook
The modern quantity theory is superior to Keynes’s liquidity preference theory because it is more complex, specifying three types of assets (bonds, equities, goods) instead of just one (bonds).
In Friedman’s theory, velocity is no longer a constant and does not assume that the return on money is zero. Instead, it is highly predictable.
Unlike the liquidity preference theory, Friedman’s modern quantity theory predicts that interest rate changes should have little effect on money demand.
Md / Plv: f (Pi varies directly with, ERoB – ERoM varies indirectly with, ERoS – ERoM varies indirectly with, EIf – ERoM varies indirectly with)
The reason for this is that Friedman believed that the return on bonds, stocks, goods, and money would be positively correlated, leading to little change in ERoB – ERoM, ERoS – ERoM, or EIf – ERoM because both sides would rise or fall about the same amount.
Interest rates did not strongly affect the demand for money, so velocity was predictable and the quantity of money was closely linked to aggregate output. Except when nominal interest rates hit zero (as in Japan), the demand for money was somewhat sensitive to interest rates, it's a liquidity trap, where money demand is perfectly horizontal. Since the money demand became more sensitive to interest rate changes, velocity, output, and inflation became harder to predict.
Transfers of stock or public debt are there equivalent to payments in species. So, velocity rises when there are money substitutes, highly liquid assets that allow economic agents to earn interest.
Not as much money supply was needed to support the GDP and price level. Velocity can rise during the period that government debts are large. It then dropped as the government paid off the debt, requiring the use of more M1.
Reference
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.
20.2 Liquidity Preference Theory #Notebook
The John Maynard Keynes developed the liquidity preference theory, the equation of exchange:
MV = PY = Nominal GDP = Price Level x Real GDP
M = money supply
V = velocity
P = price level
Y = output
Money Supply x Velocity = Price Level x Output
Classical quantity theorists used the equation of exchange as the causal statement, the increases in the money supply lead to proportional increases in the price level.
Although a good approximation of reality, the classical quantity theory could not explain why velocity was pro-cyclical and why it increased during business expansions and decreased during recessions.
Therefore Keynes searched for a better theory to explain these situations.
So, why do economic agents hold money?
Transactions: To make payments. As their incomes rise, do the number and value of those payments, so this part of money demand is proportional to income. Transaction demand for money is negatively related to interest rates. When interest rates are high, people will hold as little money for transaction purposes because people tend to only liquidate them when needed.
When rates are low, people will hold more money for transaction purposes because it isn’t worth the brokerage fees to play with bonds very often.
Precautions: To keep some spare cash lying around as a precaution. It is directly proportional to income. The lure of high-interest rates offsets the fear of the devil. When rates are low, it's better to play it safe. So the precautionary demand for money is also negatively related to interest rates.
Speculations: People hold larger money balances when rates are low. Money demand and interest rates are inversely related.
Keynes’s ideas can be stated as Md / P = f ( i <−>, Y <+> )
Md/P = demand for real money balances
f means “function of” (this simplifies the mathematics)
i = interest rate
Y = output (income)
<+> = varies directly with
<−> = varies indirectly with
Keynes’s view was superior to the classical quantity theory of money because he showed that velocity is not constant.
Reference
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.
20.1 The Quantity Theory #Notebook
If inflation erodes the purchasing power of the unit of account, economic agents will want to hold higher nominal balances to compensate.
Md / Plv: f (Pi varies directly with, ERoB – ERoM varies indirectly with, ERoS – ERoM varies indirectly with, EIf – ERoM varies indirectly with)
Md / P = demand for real money balances
Md = money demand
Plv = price level
f means “function of” (not equal to)
Pi = Permanent income
ERoB – ERoM = the expected return on bonds - the expected return on money
ERoS – ERoM = the expected return on stocks (equities) minus the expected return on money
EIf – ERoM = expected inflation minus the expected return on money
According to Friedman's theory, the demand for real money balances increases when permanent income increases and declines when the expected returns on bonds, stocks, or goods increases versus the expected returns on money, which includes both the interest paid on deposits and the services banks provide to depositors.
Money demand is where the action is, because the central bank determines what the money supply will be, so we model it as a vertical line.
Before the rise of modern central banking in the 20th century, the supply curve was sloped upward. Early monetary theorists did not discuss much of the nature of money demand since they also had to worry about the nature of the money supply. Under a specie standard, money was supplied exogenously.
Consider the interest rate as the price of money on the vertical line, so when interest is high, more people want to supply money to the system because seigniorage is higher. And then, more people want to form banks, find ways of issuing money, and extant bankers want to issue more money (notes, and deposits).
Just like the price of gold or oil. When its price is low, there is less incentive to find more. But, when the price is high enough, more people want to go out to find more new gold veins or oilfields, or even more crimes associated with it.
If the return on financial investments decreases, they will want to hold more money because its opportunity cost is lower.
If inflation expectations increase, but the return on money doesn’t, people will want to hold less money because the relative return on goods (land, gold, turnips) will increase.
Reference
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.
19.1 The Trilemma, or Impossible Trinity #Notebook
The Free Floating Regime
The foreign exchange market that monetary authorities allow world markets to determine the prices of different currencies in terms of one another. The free float was characterized by tremendous exchange rate volatility and unfettered international capital mobility.
Between World War II and the early 1970s, much of the world was on a managed, fixed-FX regime called the Bretton Woods System. Before that, many nations were on the gold standard.
It's the prevailing regimes when nations determine their monetary relationship with the rest of the world individually.
In the 19th century, there are silver standard, gold standard, floating in wartime, maintain fixed exchange rates (usually against USD). But just as no country can do away with scarcity or asymmetric information, none can escape the trilemma, also known as the impossible trinity.
It is an economic decision-making theory. Unlike a dilemma, two options, a trilemma offers three solutions to a complex problem. A trilemma suggests that countries have three options to choose from when making monetary policy decisions, the free flow of capital, fixed exchange rate, and independent monetary policy.
However, the options of the trilemma are conflictual because of mutual exclusivity that makes only one option of the trilemma achievable in one shot. The theory highlights the instability inherent in using the three primary options available to a country.
Image by Julie Bang © Investopedia 2019
A: If a country can choose to fix exchange rates with one or more countries and have a free flow of capital with others, then the independent monetary policy is not achievable. The interest rate fluctuations would create currency arbitrage stressing.
B: Fixed exchange rates among all nations and the free flow of capital are mutually exclusive. Only one can be chosen at a time. If there is a free flow of capital, there cannot be fixed exchange rates.
C: If a country chooses fixed exchange rates and independent monetary policy it cannot have a free flow of capital. Because fixed exchange rates and the free flow of capital are mutually exclusive.
Briefly summarize, only two of the three holy grails of international monetary policy, fixed exchanged rates, international financial capital mobility, and domestic monetary policy discretion can be satisfied at once.
In history, the United States and Great Britain abandoned the specie standard and allowed their currencies to float quite freely during wartime since they found the specie standard costly and preferred instead to float with free mobility of financial capital and also allowed them to borrow abroad while simultaneously gaining discretion over domestic monetary policy.
Reference
Majaski, C. (2020, August 28). Trilemma Presents Three Equal Options but Only One is Possible at a Given Time. Retrieved October 15, 2020, from https://www.investopedia.com/terms/t/trilemma.asp
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