BRINNER 1 902 mit 07 ppt The Circular

BRINNER 1 902 mit 07. ppt The Circular Flow of Spending and Income, “Multipliers”, “IS-LM Lecture 7

The Circular Flow-in a closed economy BRINNER 2 902 mit 07. ppt Excise Taxes Spending on Purchases of Goods Saving Wages, Profits, Rents Payroll & Income Tax Production of Goods

The Circular Flow-in a closed economy BRINNER 3 902 mit 07. ppt Excise Taxes Spending on Purchases of Goods Saving Wages, Profits, Rents Payroll & Income Tax Production of Goods

The Circular Flow-in an open economy BRINNER 4 902 mit 07. ppt Imported Goods Export Demands Excise Taxes Spending on Purchases of Goods Saving Production of Domestic Goods Wages, Profits, Rents Payroll & Income Tax

The Multiplier BRINNER 5 902 mit 07. ppt “Multiplier” represents feedback effects within the circular flow of a change in a previous assumption u Obviously, feedback effects are greater the less leakage there is in the circular flow u The

The “IS” Curve u The IS Curve is the name given equilibrium set of points denoting – total spending corresponding to each interest rate, – for any given fiscal policy and international setting u GNP = C+I+X-M +G u= GNP ( G, T, i, GNPW ) BRINNER 6 902 mit 07. ppt

The Reduced Forms of the 7 Behavioral Equations u C=C BRINNER 7 902 mit 07. ppt ( G, T, i, GNPW ) u I = I ( G, T, i, GNPW ) u M = M ( G, T, i, GNPW ) u X = X ( G, T, i, GNPW ) u GNP = C+I+X-M +G u= GNP ( G, T, i, GNPW ) u YD = GNP - T u RP = RP ( GNP) = RP( G, T, i, GNPW )

The GNP Reduced Form Equation is a Useful Summary l. GNP BRINNER 8 902 mit 07. ppt = C+I+X-M +G= GNP ( G, T, i, GNPW ) Solve it for GNP=f(i) in 2 dimensions yields the IS curve i= INTEREST RATE GNP 2= GNP(G 2, T 1) GNP 1= GNP(G 1, T 1) GNP=NATIONAL SPENDING/OUTPUT

The “LM” Curve u Previously, BRINNER 9 902 mit 07. ppt we described interest rates as being a policy decision made by the Federal Reserve in reaction to the level of economy activity : i = f ( GNP). How they achieved this by manipulating reserves and money was implicit in the function. u We could go behind this to look at private demand for money as a function of interest rates and income : the LM Curve

The “LM” Curve u Private BRINNER 10 902 mit 07. ppt demand for money as a function of interest rates and income : the LM Curve u Define “Money” and its portfolio alternatives u Motivations to hold money u Motivations to hold bonds, stocks, durable goods u Combine to motivate demand for money: – Positively correlated with spending – Negatively correlated with interest rates

The “LM” Curve u Solve BRINNER 11 902 mit 07. ppt M/p= Liquidity = f( i , GNP) for i u Plot it in 2 dimensions ( i vs GNP ) for any given level of M/p u This is the “LM” Curve showing points of equilibrium (Liquidity Demanded = Money Supply): – For a given M/p, higher GNP encourages money holding, thus equilibrium requires a higher i to discourage/offset the GNP stimulus

Private Motivation to Hold Money u Keynes’: BRINNER 12 902 mit 07. ppt current transactions, precautionary (possible future transactions), speculative (maximizing return on all assets in uncertain world) u Zero sum game: your income and accumulated wealth in by the end of each period must be consumed or saved; if saved, a form of saving must be chosen u Your choice of “money” as the savings vehicle is a choice against all other options, and is made on the basis of relative tangible and intangible yields and their risks.

Why Is There Such a Focus on “Money? ” Rather Than Other Assets? u 1. BRINNER 13 902 mit 07. ppt Tradition: it was originally distinctive because it paid no tangible yield and was the only “perfectly liquid” asset. u 2. The central bank was thought to have greater control over its supply.

Transactions demand u Classic BRINNER 14 902 mit 07. ppt Tobin-Baumol model – per capita M=sq rt (tc*per cap inc / 2 i) – M=N * sq rt (tc* Y / N / 2 i) – log(M)=. 5* (log(N)+log(Y) +log(tc) -log(i)) - log(2) u Be careful about defining Y, the spending measure for private holding: it’s not GNP. Why? u Remember this is only the transactions demand component. Note consensus long-run spending elasticity is close to 1.

Precautionary Demand u Demand BRINNER 15 902 mit 07. ppt to meet emergencies or other needs for large purchases where liquidity is an advantage? u How do you think these would relate to Y, i ?

Speculative Demand u. A BRINNER 16 902 mit 07. ppt desire to hold money even with a known low nominal return and only the risk of inflation, versus other financial assets that have capital risk(due to changing interest rates) as well, or versus real goods that are illiquid/ expensive to sell to raise funds. u Explain capital risk on bonds: why the price varies with the market rate after original issue. u Explain risk-return tradeoff. u Ask and explain how speculative demand would relate to income, and to interest rates.

BRINNER 17 902 mit 07. ppt The “LM” Curve u For a given M/p, higher GNP encourages money holding, thus equilibrium requires a higher i to discourage/offset the GNP stimulus i= Interest Rate ui =L( M/p, GNP ) GNP = National Spending / Output

The “LM” Curve is a Hidden Piece of the First Model u Private Demand for Money – M/p (real demand) = f ( i , GNP) – or, i = f ( M/p , GNP ) u The Fed Reactions – Central Bank Supply of Money – M/p = g ( GNP) u If Demand=Supply= ( M / p ) u Then, i = f ( g(GNP) , GNP) = f ( GNP ), the Fed reaction function of the First Model BRINNER 18 902 mit 07. ppt

Elementary Monetarism BRINNER 19 902 mit 07. ppt u velocity=GNP/M 1 u GNP=P * T(Real Transactions) u thus v=P * V / M u or M * v = P * T, known as the quantity equation, the core of the quantity theory of money, whose key conclusion is P = M *(Y/v) and strict monetarism asserts Y, v are fixed in equilibrium u but velocity is not fixed; rather it is sensitive to interest rates

The Velocity of Money (M 1) vs. the Treasury Bill Rate (GDP/M 1) (percent) BRINNER 20 902 mit 07. ppt