Modern Monetary Theory:

Keynes argued that there were three reasons for holding money:

1. Transactions motive

2. Precautionary motive

We will suggest three different rationales for the downward sloped curve: the real balances effect, the interest rate effect, and the foreign purchases effect. The Real Balances Effect “Real balances” refers to the purchase power of a given amount of money in circulation. The money supply M is 1,000 and the price level P is 2. Graph the supply and demand for real money balances. What is the equilibrium interest rate? Suppose that the money demand function is (M/P)' = 1,000 - 100r, where r is the interest rate in percent. The money supply M is.

3. Speculative motive - holdings of money as a wealth asset

The idea behind the speculative motive is that individuals will shift their wealth between liquid and illiquid assets, i.e.,
between money and bonds or stocks, as the interest rate changes.

Graph The Supply And Demand For Real Money Balances

For this reason, Keynes called the demand for money liquidity preference.

The liquidity preference function says that the demand for money depends on both the level of real GDP and on the
rate of interest. We will write it as a linear function, and we will express money as real balances, that is, we will look
at the purchasing power of the amount of money demanded. So, real balances are M₁/P.

[M₁/P]_D = demand for real money balances

= L(r,Y) = f*r - g*Y f>0, 0<g<1

On a diagram, with the interest rate on the vertical axis and real money balances on the horizontal, the demand for money,
or liquidity preference, function is a downward sloping curve.

Each new value of Y will generate a new liquidity preference line.

The basic behavioral assumptions about the demand for money are that individual wealth holders want to avoid capital losses, and that all gains and losses, in the simple model, depend on expected interest rates. If rates fall, the capital market value of assets like bonds will rise, and if rates rise, the capital market value of assets like bonds will fall.

For convenience, for now, we will assume that the only interest bearing assets in the economy are bonds. Thus, in the simple case we are discussing, individual wealth holders can hold real money balances, which do not bear interest, and bonds, which do bear interest. [In reality, of course, there are assets that earn a return; time deposits, bonds, stock shares, etc.]

If real interest rates in the economy fall, individual bond holders will want to hold more real money balances and fewer bonds; they will want to sell their bonds, make capital gains, and then hold money. Falling interest rates mean that money is cheaper to hold, ie., has a lower opportunity cost.

If interest rates in the economy rise, individual bond-holders will want to buy bonds, which are getting cheaper, and hold less real money balances; the opportunity cost of holding money has risen.

In a more complicated model, with many types of assets earning a return, individuals will adjust the portfolio of wealth holdings, and not just the money versus bonds decision. If the interest rate structure changes, individuals may move their wealth around from stocks to bonds to mutual funds to savings accounts to real balances.

At his point, Keynesian theory has to address the problem of interest rate determination. In classical models like Fisher's the interest rate is determined in the market for loanable funds, i.e., at the intersection of the investment and savings functions. But, as we saw earlier, Keynes argued that savings does not depend on the interest rate. So, he argued that the intersection of the supply and demand for money determined the interest rate.

Thus, in the Keynesian model, a change in either the nominal money supply (M₁) or the price level (P)
will cause the rate of interest to change.

Further, a change in M₁ will cause a change in the rate of interest, that will then affect aggregate expenditure
by causing the level of investment, or the level of autonomous consumption to change.

We can show this be examining how monetary. We will use a money market graph, a
graph of Autonomous Spending with respect to the rate of interest, and the Aggregate Expenditure graph.

Monetary Policy: When the money supply increases, M₁ rising to M'₁, the interest rate will fall (Point E to point F in the left diagram).
This will cause Autonomous Spending to rise, (Point E to point F in the right diagram.) That will cause AE to rise, and then real GDP to rise, through the
multiplier process (Point E to point F in the bottom diagram.) [For practice, draw the results in the AD-SAS diagram. How will the increase in AE
above affect AD?]

Thus, changes in the money supply will affect real output, through changes in the interest rate.

Economists argue about the relative strength of various parameter shifts. How elastic is the liquidity preference function and
the aggregate expenditure function with respect to the interest rate?

Monetarist: The liquidity preference function is relatively inelastic, and the aggregate expenditure function is relatively elastic,
with respect to the interest rate. Short run AS is steep, but not vertical.

Keynesian: The liquidity preference function is relatively elastic, the aggregate expenditure function is relatively inelastic with respect
to the interest rate. Short run AS is not very steep.

Rational Expectations point of view: Individuals collect the best available information and act on it rationally. Wages and prices are flexible and adjust quickly. Therefore, the Classical model makes sense. We will only get involuntary unemployment if individuals mis-read available information (make mistakes) or if they do not realize what is happening. Fiscal and monetary policy will be ineffective since actors in the economy will anticipate perfectly what the policy response will be to any change, and will neutralize it. GDP will always be at its potential or natural level, i.e., the AS curve is vertical. We should rely on consistent, long-run policy rules to run the economy and to provide individuals with good information about what to expect.

KEYNESIANS AND MONETARISTS

1. Keynesians believe more strongly in fiscal policy, and Monetarists believe more strongly in monetary policy.

2. Policy lags are shorter for monetary policy than for fiscal policy, but monetary policy usually takes longer to work on the economy. Changes in G and Tx work quickly on the economy, once they are made. Friedman says monetary policy lags are 2 to 6 months. Fiscal policy can take a long time, since Congress must act on it. Automatic Stabilizers are fiscal policy tools that take effect as needed, with no Congressional or Presidential action.

Graph The Supply And Demand For Real Money Balances Equation

3. Keynesians believe the FED should control the rate of interest. Monetarists believe the FED should keep the money supply growing at a stable, if not constant, rate.

PROBLEM: If money demand shifts out autonomously, then r and M₁
will both rise, if the money supply is upward sloping. In such a case, the FED cannot control both r and M₁. If the demand for money jumps around erratically, control of the supply of money is almost impossible. M₁ must be adjusted to compensate for fluctations in r caused by the jumping-around of money demand. The FED must always consider that higher r may dampen investment and consumption, but the drop in investment spending may have serious long-run effects. The growth of the economy will slow if investment stays depressed.

Graph The Supply And Demand For Real Money Balances Among

4. Keynesians believe the short-run aggregate supply curve is relatively elastic [flat]. Monetarists believe the short-run aggregate supply curve is relatively inelastic [steep].

Graph The Supply And Demand For Real Money Balances Within

5. Keynesians believe that discretionary stabilization policies, both fiscal and monetary, are desireable. They are not convinced that economy will operate well on its own. Monetarists believe that lags and uncertainties make any form of discretionary stabilization policy very difficult, if not counter-prod