Relationship between the

Money and Goods Markets

Relationship between the Money and
Goods Markets

Effects of Monetary
Changes on
National Income
 MONEY 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
 Effect of a rise in money supply:
the traditional Keynesian transmission mechanism

MS
Rate of interest

r1

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

MS
Rate of interest

Rate of interest
r1 r1

L I

O O I1
Money Investment
 Effect of a rise in money supply:
the traditional Keynesian transmission mechanism

J1
(= I1 + G + X)
O Y1
 Effect of a rise in money supply:
the traditional Keynesian transmission mechanism

MS MS '
Rate of interest

Rate of interest
r1 r1

r2 r2

L I

O O I1 I2
Money Investment

(a) Stage 1: MS↑ → r ↓ (b) Stage 2: r ↓ → I ↑

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

J2
(= I2 + G + X)
J1
(= I1 + G + X)
O Y1 Y2

(c) Stage 3: I ↑ → J ↑ → Y ↑
 MONEY AND NATIONAL INCOME

• Limitations of the interest rate

transmission mechanism
– possible problems with stage 1: money –
interest rate link
• elastic demand for money
 An elastic liquidity preference curve

MS MS' MS"
Rate of interest

r1
r2 L

O
Money
 MONEY AND NATIONAL INCOME

• Limitations of the interest rate

transmission mechanism
– possible problems with stage 1: money –
interest rate link
• elastic demand for money
• unstable demand for money
The effect on interest rates of a fluctuating demand for money

MS

r1
Rate of interest

L'

L
O
Money
 MONEY AND NATIONAL INCOME

• Limitations of the interest rate

transmission mechanism
– possible problems with stage 1: money –
interest rate link
• elastic demand for money
• unstable demand for money

– possible problems with stage 2: interest rate

– investment link
 MONEY AND NATIONAL INCOME

• Limitations of the interest rate

transmission mechanism
– possible problems with stage 1: money –
interest rate link
• elastic demand for money
• unstable demand for money

– possible problems with stage 2: interest rate

– investment link
• inelastic investment demand
 Different views on the demand for investment
Rate of interest

r1

I
O I1
Investment

(a) Keynesian
 Different views on the demand for investment

Rate of interest
Rate of interest

r1 r1
I

I
O I1 O I1
Investment Investment

(a) Keynesian (b) New classical / Monetarist

 Different views on the demand for investment

Rate of interest
Rate of interest

r2
r1 r1
I

I
O I2 I1 O I1
Investment Investment

(a) Keynesian (b) New classical / Monetarist

 Different views on the demand for investment

Rate of interest
Rate of interest

r2 r2
r1 r1
I

I
O I2 I1 O I2 I1
Investment Investment

(a) Keynesian (b) New classical / Monetarist

 MONEY AND NATIONAL INCOME

• Limitations of the interest rate

transmission mechanism
– possible problems with stage 1: money –
interest rate link
• elastic demand for money
• unstable demand for money

– possible problems with stage 2: interest rate

– investment link
• inelastic investment demand
• unstable investment demand
 The effects of interest rate changes,
given an unstable investment demand curve
Rate of interest

r0
r1

I1

O Q0 Q1

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

The fall in interest rates is

accompanied by an increase
Rate of interest

in business confidence

r0
r1

I2
I1

O Q0 Q1 Q2

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

The fall in interest rates is

accompanied by a decrease
Rate of interest

in business confidence

r0
r1

I1
I3
O Q3 Q0 Q1

Investment
 MONEY AND NATIONAL INCOME

• The exchange-rate transmission

mechanism
– the stages
• money supply – interest rate link

• interest rate – exchange rate link

• exchange rate – import and export link

 The exchange rate transmission mechanism

MS
Rate of interest

r1

O
Money
 The exchange rate transmission mechanism

MS S1
Rate of interest

Exchange rate
r1
er1

L D1

O O
Money Quantity of sterling
 The exchange rate transmission mechanism

S1

M
Exchange rate

Exchange rate
er1 er1

D1
X
O X1 M1 O
Exports (X), Imports (M) Quantity of sterling
 The exchange rate transmission mechanism

W, J

W1 (= S + M1 + T)

J1 (= I + X1 + G)

O Y1 Y
 The exchange rate transmission mechanism

MS MS ' S1
Rate of interest

Exchange rate
r1
er1
r2

L D1

O O
Money Quantity of sterling

(a) Stage 1: MS↑ → r ↓

 The exchange rate transmission mechanism

MS MS ' S1
S2
Rate of interest

Exchange rate
r1
er1
r2

L er2 D1
D2
O O
Money Quantity of sterling

(a) Stage 1: MS↑ → r ↓ (b) Stage 2: MS↑ , r ↓ → er ↓

 The exchange rate transmission mechanism

S1
S2

Exchange rate
er1

er2 D1
D2
O O
Quantity of sterling

(b) Stage 2: MS↑ , r ↓ → er ↓

 The exchange rate transmission mechanism

S1
S2
M
Exchange rate

Exchange rate
er1 er1

er2 er2 D1
X D2
O M2 X1 M1 X2 O
Exports (X), Imports (M) Quantity of sterling

(c) Stage 3: er ↓ → M ↓ , X ↑(b) Stage 2: MS↑ , r ↓ → er ↓

 The exchange rate transmission mechanism

W, J

W1 (= S + M1 + T)

W2 (= S + M2 + T)
J2 (= I + X2 + G)
J1 (= I + X1 + G)

O Y1 Y2 Y

(d) Stage 4: M ↓ , X ↑ → Y↑
 MONEY AND NATIONAL INCOME

• The exchange-rate transmission

mechanism
– the stages
• money supply – interest rate link

• interest rate – exchange rate link

• exchange rate – import and export link

– the strength of the effect

 MONEY AND NATIONAL INCOME

• The exchange-rate transmission

mechanism
– the stages
• money supply – interest rate link

• interest rate – exchange rate link

• exchange rate – import and export link

– the strength of the effect

– the variability of the effect

 MONEY AND NATIONAL INCOME

• 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 circulation
35 2.40

M0 velocity
2.20
30
2.00

M4 velocity
1.80
M0 velocity

25

1.60

20
1.40

1.20
15
1.00

10 0.80
1970 1975 1980 1985 1990 1995 2000
 M0 and M4 velocities of circulation
35 2.40

M0 velocity
2.20
30
2.00

M4 velocity
1.80
M0 velocity

25

1.60

20
1.40

1.20
15
1.00

10 0.80
1970 1975 1980 1985 1990 1995 2000
 M0 and M4 velocities of circulation
35 2.40

M0 velocity
2.20
30
2.00

M4 velocity
1.80
M0 velocity

25

1.60

20
1.40
M4 velocity
1.20
15
1.00

10 0.80
1970 1975 1980 1985 1990 1995 2000
Relationship between the Money and
Goods Markets

Monetary Effects of
Changes in the
Goods Market
MONETARY EFFECTS OF GOODS
MARKET CHANGES
• Monetary effects of changes in
aggregate demand
– effect on interest rates

– effect on national income

 The monetary effects of a rise in injections

W, J

J1

O Y1 Y

(a) The goods market

 The monetary effects of a rise in injections
Rate of
W, J interest
MS

r1
W

J1 L1

O Y1 O
Y Money

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

 The monetary effects of a rise in injections
Rate of
W, J interest
MS

An expansionary
fiscal policy

r1
W
J2
J1 L1

O Y1 Y2 O
Y Money

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

 The monetary effects of a rise in injections
Rate of
W, J interest
MS

An expansionary Effect on the

fiscal policy demand for money
r2

r1
W
J2 L2
J1 L1

O Y1 Y2 O
Y Money

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

 The monetary effects of a rise in injections
Rate of
W, J interest
MS MS 2

An expansionary Accommodating
fiscal policy increase in the
r2 money supply
r1
W
J2 L2
J1 L1

O Y1 Y2 O
Y Money

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

MONETARY EFFECTS OF GOODS
MARKET CHANGES
• 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 money

MS
Rate of interest

r1
L

O
Money

(a) Keynesian
 Different views on the demand for money

MS MS

Rate of interest
Rate of interest

r1
L r1

L
O O
Money Money

(a) Keynesian (b) New classical / Monetarist

 Different views on the demand for money

MS MS

Rate of interest
Rate of interest

r2
r1 L'
L r1

L
O O
Money Money

(a) Keynesian (b) New classical / Monetarist

 Different views on the demand for money

MS MS

Rate of interest
Rate of interest

r2

r2
r1 L'
L r1
L'
L
O O
Money Money

(a) Keynesian (b) New classical / Monetarist

 Different views on the demand for investment
Rate of interest

r1

I
O I1
Investment

(a) Keynesian
 Different views on the demand for investment

Rate of interest
Rate of interest

r1 r1
I

I
O I1 O I1
Investment Investment

(a) Keynesian (b) New classical / Monetarist

 Different views on the demand for investment

Rate of interest
Rate of interest

r2
r1 r1
I

I
O I2 I1 O I1
Investment Investment

(a) Keynesian (b) New classical / Monetarist

 Different views on the demand for investment

Rate of interest
Rate of interest

r2 r2
r1 r1
I

I
O I2 I1 O I2 I1
Investment Investment

(a) Keynesian (b) New classical / Monetarist

MONETARY EFFECTS OF GOODS
MARKET CHANGES
• 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
• Money supply: exogenous or
endogenous?
Relationship between the Money and
Goods Markets

ISLM Analysis
 ISLM ANALYSIS

• The goods and money markets

• The IS curve
– deriving the IS curve
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Assume that an interest
rate of r1 gives investment
of I1 and saving of S1
S1 (W1)

I1 (J1)
O
Rate of interest

r1

O
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Assume that an interest
rate of r1 gives investment
of I1 and saving of S1
S1 (W1)

I1 (J1)
O
Y1
Rate of interest

r1

O
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Assume that an interest
rate of r1 gives investment
of I1 and saving of S1
S1 (W1)

I1 (J1)
O
Y1
Rate of interest

r1

O
Y1
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Assume that an interest
rate of r1 gives investment
of I1 and saving of S1
S1 (W1)

I1 (J1)
O
Y1
Rate of interest

r1 a

O
Y1
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Now assume that the interest
rate falls to r2, giving
investment of I2 and saving of S2
S1 (W1)
S2 (W2)
I2 (J2)
I1 (J1)
O
Y1 Y2
Rate of interest

r1 a

r2

O
Y1
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Now assume that the interest
rate falls to r2, giving
investment of I2 and saving of S2
S1 (W1)
S2 (W2)
I2 (J2)
I1 (J1)
O
Y1 Y2
Rate of interest

r1 a

r2

O
Y1
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Now assume that the interest
rate falls to r2, giving
investment of I2 and saving of S2
S1 (W1)
S2 (W2)
I2 (J2)
I1 (J1)
O
Y1 Y2
Rate of interest

r1 a

r2
b

O
Y1
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Now assume that the interest
rate falls to r2, giving
investment of I2 and saving of S2
S1 (W1)
S2 (W2)
I2 (J2)
I1 (J1)
O
Y1 Y2
Rate of interest

r1 a

r2
b

IS
(J = W)
O
Y1
 ISLM ANALYSIS

• The goods and money markets

• The IS curve
– deriving the IS curve
– elasticity of the IS curve
 The IS curve

Injections, Withdrawals S1 (W1)

S2 (W2)
I2 (J2)
I1 (J1)
O
Y1 Y2
Rate of interest

r1 a

r2
b

IS
(J = W)
O
Y1
 ISLM ANALYSIS

• The goods and money markets

• The IS curve
– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
 The IS curve

Injections, Withdrawals S1 (W1)

S2 (W2)
I2 (J2)
I1 (J1)
O
Y1 Y2
Rate of interest

r1 a

r2
b

IS
(J = W)
O
Y1
 ISLM ANALYSIS

• The goods and money markets

• The IS curve
– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve
 ISLM ANALYSIS

• The goods and money markets

• The IS curve
– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve
– deriving the LM curve
 Money market equilibrium: deriving the LM curve
Assume that at a level of
national income, Y1,
the demand for money is L'
Rate of interest

Rate of interest
L'

O O Y1
Money National income
 Money market equilibrium: deriving the LM curve
Assume that at a level of
national income, Y1,
the demand for money is L'
MS
Rate of interest

Rate of interest
L'

O O Y1
Money National income
 Money market equilibrium: deriving the LM curve
Assume that at a level of
national income, Y1,
the demand for money is L'
MS
Rate of interest

Rate of interest
r1 r1

L'

O O Y1
Money National income
 Money market equilibrium: deriving the LM curve
Assume that at a level of
national income, Y1,
the demand for money is L'
MS
Rate of interest

Rate of interest
r1 r1
c

L'

O O Y1
Money National income
 Money market equilibrium: deriving the LM curve
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
MS
Rate of interest

Rate of interest
r1 r1
c
L"
L'

O O Y1 Y2
Money National income
 Money market equilibrium: deriving the LM curve
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
MS
Rate of interest

Rate of interest
r2 r2
r1 r1
c
L"
L'

O O Y1 Y2
Money National income
 Money market equilibrium: deriving the LM curve
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
MS
Rate of interest

Rate of interest
d
r2 r2
r1 r1
c
L"
L'

O O Y1 Y2
Money National income
 Money market equilibrium: deriving the LM curve
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
MS LM
Rate of interest

Rate of interest
d
r2 r2
r1 r1
c
L"
L'

O O Y1 Y2
Money National income
 ISLM ANALYSIS

• The goods and money markets

• The IS curve
– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve
– deriving the LM curve
– elasticity of the LM curve
 The LM curve

MS LM
Rate of interest

Rate of interest
d
r2 r2
r1 r1
c
L"
L'

O O Y1 Y2
Money National income
 ISLM ANALYSIS

• The goods and money markets

• The IS curve
– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve
– deriving the LM curve
– elasticity of the LM curve
– shifts in the LM curve
 The LM curve

MS LM
Rate of interest

Rate of interest
d
r2 r2
r1 r1
c
L"
L'

O O Y1 Y2
Money National income
 ISLM ANALYSIS

• The goods and money markets

• The IS curve
– deriving the IS curve
– elasticity of the IS curve
– shifts in the IS curve
• The LM curve
– deriving the LM curve
– elasticity of the LM curve
– shifts in the LM curve
• Equilibrium in the model
 Equilibrium in both the goods and money markets
LM
Rate of interest

IS

O
National income
 Equilibrium in both the goods and money markets
LM
Assume that national income
is currently at a level of Y1
Rate of interest

IS

O Y1
National income
 Equilibrium in both the goods and money markets
LM
This gives a rate of
interest of r1 (point a)
Rate of interest

a
r1

IS

O Y1
National income
 Equilibrium in both the goods and money markets
LM
But at r1, national income
is below the goods market
equilibrium level (Y2)
Rate of interest

a b
r1

IS

O Y1 Y2
National income
 Equilibrium in both the goods and money markets
But as income rises, so there
LM
will be a movement up the
LM curve. The interest rate
will rise, thereby reducing
national income below Y2.
Rate of interest

a b
r1

IS

O Y1 Y2
National income
 Equilibrium in both the goods and money markets
LM
Rate of interest

re

IS

O Ye
National income
 ISLM ANALYSIS

• Full effects of changes in the goods and

money markets
– effects of changes in the goods market
ISLM analysis of changes in the goods and money markets

LM
Rate of interest

r1

IS

O Y1
National income
ISLM analysis of changes in the goods and money markets

LM
A rise in
injections
Rate of interest

r2
r1

IS2

IS1

O Y1 Y2
National income
 ISLM ANALYSIS

• Full effects of changes in the goods and

money markets
– effects of changes in the goods market

– effects of changes in the money market

ISLM analysis of changes in the goods and money markets

LM1 LM2
A rise in the
money supply
Rate of interest

r1

r3

IS

O Y1 Y3
National income
 ISLM ANALYSIS

• Full effects of changes in the goods and

money markets
– effects of changes in the goods market

– effects of changes in the money market

– effects of changes in both markets

ISLM analysis of changes in the goods and money markets

A rise in both LM1 LM2

injections and
money supply
Rate of interest

r1

IS2

IS1

O Y1 Y4
National income
 ISLM ANALYSIS

• Full effects of changes in the goods and

money markets
– effects of changes in the goods market

– effects of changes in the money market

– effects of changes in both markets

• Deriving an AD curve from the ISLM

model
Deriving the AD curve from an ISLM diagram

Rate of interest (r)

LM1

a
r1
IS

Y1
National income (Y)
Price level (P)

P1 a'

Y1
National income (Y)
Deriving the AD curve from an ISLM diagram
LM2
Rate of interest (r)
LM1

b
r2
a
r1
IS

Y2 Y1
National income (Y)
Price level (P)

P2 b'

P1 a'
AD

Y2 Y1
National income (Y)
Relationship between the Money and
Goods Markets

Taking Inflation
into Account
 TAKING INFLATION INTO ACCOUNT

• The policy of inflation targeting

• AD and AS plotted against inflation
– the inflation target line
 The inflation target line

.
Rate of inflation (P)

.P
target

National income
 TAKING INFLATION INTO ACCOUNT

• The policy of inflation targeting

• AD and AS plotted against inflation
– the inflation target line
– the ADI curve
 AD plotted against inflation
the ADI curve
• why downward sloping?

.
Rate of inflation (P)

• what determines the slope?

• movements along and shifts
in the ADI curve

.P
target

ADI
O Y1
National income
 TAKING INFLATION INTO ACCOUNT

• The policy of inflation targeting

• AD and AS plotted against inflation
– the inflation target line
– the ADI curve
• why downward sloping?
• what determines the slope?
• movements along and shifts in the ADI curve

– the ASI curve

 AD and AS plotted against inflation
ASI

.
Rate of inflation (P)

.P
target
a

ADI1
O Y1
National income
 TAKING INFLATION INTO ACCOUNT

• Response to change in aggregate

demand and supply

– a change in aggregate demand

 AD and AS plotted against inflation
ASI

.
Rate of inflation (P)

.P b
.P 2

target
a c

ADI2

ADI1
O Y1 Y2 Y3
National income
 AD and AS plotted against inflation
ASI

.
Rate of inflation (P)

.P b
.P 2

target
a

ADI2

ADI1
O Y1 Y2
National income
 TAKING INFLATION INTO ACCOUNT

• Response to change in aggregate

demand and supply

– a change in aggregate demand

– a change in aggregate supply

 TAKING INFLATION INTO ACCOUNT

• Response to change in aggregate

demand and supply

– a change in aggregate demand

– a change in aggregate supply

• a temporary supply shock

 The effects of a increase in aggregate supply
(a) a temporary increase in aggregate supply
ASI1
ASI2

.
Rate of inflation (P)

.P a
.P
target

2
b

ADI1
O Y1 Y2
National income
 TAKING INFLATION INTO ACCOUNT

• Response to change in aggregate

demand and supply

– a change in aggregate demand

– a change in aggregate supply

• a temporary supply shock

• a permanent change in aggregate supply

 The effects of a increase in aggregate supply
(b) a permanent increase in aggregate supply
ASI1
ASI2
Central bank cuts
. target interest rate
Rate of inflation (P)

.P a c
.P
target

2
b

ADI2

ADI1
O Y1 Y2 Y3
National income