Lecture 51

Hi everyone, welcome to this session. The main objective of this session and the following sessions is to discuss the effects of monetary policy on aggregate outcome that is GDP and employment using the ISLM framework. So about the ISLM, the ISLM is called as that investment saving and liquidity money, this is the expansion of ISLM. So we are going to discuss, first we will discuss what is ISLM framework all about, then once you get familiar with the ISLM framework, then we will introduce the monetary policy in the ISLM framework and then we will see how in which way using the ISLM, it affects the aggregate demand and finally the GDP. The main objective of ISLM is to find the values of the interest rate and income that simultaneously equilibrate commodity market and the money market. Prior to that as you may be aware that the Keynesian general theory that means as a response to the great depression of 1930s, the birth of Keynesians which also paved the way for the birth of macroeconomics. So in the Keynesian theory at that time the symbol theory, symbol Keynesian theory, it mainly talked about that the use of fiscal policy in order to save the economy, in order to as a part of risk management in order to save the economy from recession or macroeconomic disequilibrium. Keynesian theory supported for the use of fiscal policy that is increase government expenditure and as a result increase aggregate demand and then increase aggregate demand which would finally lead to increase in GDP. And in the Keynesian general theory, it is very fundamental impenetrable and there was many debates around what Keynes really meant using his theory, his general theory. So in 1937, the Keynesians especially John Hicks, he summarized, John Hicks summarized what he saw as one of the main Keynesian contribution is the joint description of goods and financial market. This had led to the development of ISLM framework by John Hicks and Alvin Hansen. Actually the ISLM framework is mainly a tool to understand the short-term macro use for mainly for a short-term macroeconomic analysis then how changes in policy for example, fiscal and monetary policy would affect different economic variable and finally the aggregate demand and GDP. In this case, in our session, our focus is that first we identify the combination of income and interest rate that equilibrate money market that is LM. That means LM means the equilibrium in the money market which implies again the equilibrium in the money market which we have seen in the previous session that if money market is in equilibrium that means bond market is also in equilibrium. So the first we identify the combination of income and the interest rate that equilibrate the money market. Money market means the demand for money is equal to the supply of money and next subsequently we identify the combination of income and interest rate that equilibrate the goods market. We are going to call it IS model. These two sets of equilibrium combinations of interest rate and income levels are then shown to contain one combination that equilibrate both markets that means IS LM. So in the IS LM model, the final model we find out the equilibrium combination of interest rate and income levels when IS market is in equilibrium, goods market is in equilibrium, money market is in equilibrium then finally when both markets are in equilibrium at a combination of interest rates and income level. So before proceeding further in the IS LM we make few assumptions. One assumption is that to find a unique point of equilibrium where goods market and money market are equilibrium with a combination of equilibrium interest rate and income level. We have to assume that policy variables such as money supply, government expenditure, tax are fixed at some levels. And other autonomous influences on income and interest rates for example state of business expectation that affects investment that also assumed to be fixed. So further assumption is that main assumptions here is that to find a unique point of equilibrium we assume that clearly the fiscal policy variable that is government expenditure and tax are fixed at some levels. And coming to the monetary policy variable we assume that money supply is also fixed at some levels. So as I mentioned other autonomous way influences on income and interest rate that the state of business expectations and that affect investment also must also be assumed to be fixed. Let us first discuss the money market and the derivation of the LM schedule and LM curve. The LM curve shows the combination of interest rates and the levels of output such that money demand equals money supply that means there is equilibrium in the money market. You know that equilibrium in the money market happens when the money demand is equal to money supply. The LM curve is derived in two steps one first we explain why money demand depends on interest rates and income. This also called as the theory of real money balances rather than nominal. People demand money not for just for the sake of demanding money but for the purchasing power or to the real money balances what the money can do with that money what they can do. So that means the real purchasing power that the theory of real money balances. Second one equate the money demand with money supply and money supply anyway is exogenously determined then the equate money demand with money supply and find combinations of income and interest rates that maintain equilibrium in the money market. So here rate of interest and income that the small letter or rate of interest capital letter Y that is the income GDP these are the pairs meeting this criteria or points on a given LM curve. So coming to the first aspect demand for money as we mentioned the demand for money is a demand for real money balances. It means people are concerned with how much their money can buy rather than the number of dollars or rupees in their pockets. So the demand for real balances depends on one is the real income that the people hold money to pay for their real purchases which in turn depend on their income that is one. Second one that means clearly the money demand here that depends on income it also called the demand for money for transaction purpose. And the second variable is the interest rate the cost of holding money the opportunity cost of holding money. So we know that in a market when we put all the assets into money and bond and we know that for holding money, money is demanded mainly for transaction purpose and precautionary motive and by holding money you won't get any interest income. So but when you alternatively suppose if the assets network your assets when you distribute between money that is for transaction purpose when you keep it for transaction purpose you get zero interest income. But when you keep more money for money keep more money more of your net worth or assets in the form of money then actually you are forgoing your interest income that means here if you invest in bond you are going to get interest income. So that means the interest rate the rate of interest here is the opportunity cost of holding money. So when the demand for money these two things matters one is the real income then higher your level of real income that means the more will be the demand for money because you need more money for to meet your transaction and precautionary purposes. However the interest rate that is the opportunity cost that means the cost of holding money higher the rate of interest means the money demand will be low. So the total money demand we can write is a function of total money demand is a function of income real income and the rate of interest and where you can see that money demand in the Keynesian model depends on positively on income because of the transaction demand that means higher the income then higher the transaction demand for money and however it varies inversely with the rate of interest because the point we discuss here when the rate of interest is high. Suppose the rate of interest is higher than the natural rate of interest suppose let us call it natural rate of interest that means the current rate of interest is greater than the natural rate of interest there is a expectation that in the future rate of interest will come down. So the as a result there will be less demand for there is less speculative demand for money because you know that when the rate of interest is going to decline in the future this would lead to capital loss then as a result the people demanding money. Now when the future suppose when the rate current rate of interest is greater than the natural rate of interest people anticipate that in the future the expected rate of interest is going to decrease in the future because currently it is above the natural rate then when the rate of interest decline then the you know that the expected price of bond price of bond going to increase right. The expected rate of price on price of bonds is going to increase that means people are going to make capital gains in the future right. So the expected capital gains increase the expected capital gains again expected capital gains increase. So as a result of the total assets they will be keeping putting more money in the bond market that means the money meant for speculative demand decreases if the when the rate of interest is greater than the natural rate of interest. So higher rate of interest means low speculative demand for money and the other one when the rate of interest is high the amount of transaction balance held at any given income level at any income level also declines because high interest rate means as the interest rate increases the opportunity cost of holding such balances increases then people will reduce their transaction demand for money. So to summarize this one the demand for money is inversely related to the rate of interest because speculative demand for money higher the rate of interest lower the speculative demand for money and secondly higher the rate of interest lower will be the transaction demand for money because of the opportunity cost of holding money because money does not pay any interest but investing in bond market it gives them interest income. So higher the interest income high interest rate they will invest more money in the bond market that means they will reduce transaction demand for money. Let us now construct the LM schedule so we have as I mentioned at the beginning money supply is exogenously determined this is a policy variable exogenously determined is already fixed and the central bank the monetary authority the decision to issue decision to increase the money supply for them is a policy decision is not depend upon the rate of interest. It depends upon the economic conditions and the objectives of the monetary policy in order to satisfy in order to fulfill their objective they will be changing the money supply accordingly. So in our discussion we here we make that money supply since money supply is exogenously determined in our analysis we assume that money supply is fixed. So the total money demand is equal to that is a function of real income and rate of interest. So we can write it that the money demand is equal to a fixed component plus positively related to the GDP that the coefficient C1 that is positively related to the income and negatively related to the rate of interest. So let us call it that is the inverse that a minus C2r. So C1 and C2 this is the coefficient that we are going to estimate later on. So that is the fraction of that is the coefficient of related to income and rate of interest. So the money demand is equal to C0 plus C1y minus C2r that exactly replicating the positive relation with the money demands positive relationship with the income and negative relationship with the inverse relationship with the rate of interest. Since the money supply is already given so let us see in the equilibrium in order to attain equilibrium money supply should be equal to money demand. Money demand is nothing but we already know this C0 plus C1y minus C2r. Later on we will be using this equation while continuing our discussion with the LM schedule. For the moment let us take that this is money supply is equal to money demand then C0 is equal to C0 plus C1y minus C2r. In order to attain the money market equilibrium we are going to show that at the higher levels of income higher interest rates are required. Then we are going to show that LM schedule slopes upward. So since our assumption is that money supply is fixed that we are having in this diagram I am going to show I am putting here the rate of interest on the y axis the quantity of money on the x axis and here first about the money supply diagram it is a vertical one this is interest inelastic this is exogenously fixed and it is arbitrarily fixed by the monetary authority. At a given point of time this is the money supply that is MS0. Then let us begin the at a given level of income suppose at a given level of income for example Y0. So here this is the given level of income and at a given rate of interest for example R0 we can see that this is the money demand curve. So you can see that at the given money demand at a given income level Y0 MD is the money demand curve. So MD is the money demand curve is a downward slopping demand curve you know that higher the rate of interest you can see that lower the money demand. When the rate of interest declines then the money demand will increase that means when the rate of interest decline means the transaction demand for money increase because opportunity cost of holding money decrease and again the speculative demand for money also increases you know why because when the rate of interest decreases there is an expectation that in the future rate of interest will increase when the rate of interest is going to increase in the future the capital gain from the investment in bond people are anticipating a capital loss because rate of interest is going to increase then there will be less demand for bond that means increase demand for money that means speculative demand for money also increases. So then finally you can see that the equilibrium will be attaining where money demand is equal to money supply that is at a point A. So this is this demand curve is drawn that the MD demand curve MD at a Y0 is drawn when the income is Y0 where the GDP is Y0. So this is the equilibrium point and the rate of interest is determined at R0 and this is the money supply and money demand. So money supply and money demand is equilibrium at this point for example let us call it money supply is 100 billion just at this point assume that money supply is equal to 100 billion. So the money demand is also going to be equal to 100 billion that is the MD. So MD so at this point you can see that MS is equal to MD at this point of A. Now assume that there is an increase in income from Y0 to Y1 then further from Y1 to Y2. So when there is suppose let us see that there is increase in income from Y0 to Y1 there is an increase in income what you can see that when there is an increase in income what we have discussed here that in our session that increase in income lead to increase in the transaction demand for money. Because now they have suppose initially the GDP suppose take the GDP for example 800 billion suppose that is initial GDP that is Y0 is 800 billion now Y1 become for example 900 billion then you know that here our assumption is that MS is already fixed. MS is fixed then in order to transact this 900 billion of goods and services in real terms they need more money for transaction purpose. So as a result they will be demanding more money then you know that when they are demanding more money when the demand for money increases demand for money increases means demand for because their total assets is money and bonds when the demand for money increases that means the demand for bond decreases when the demand for bond decreases means rate of interest the price of bond decreases. So we can see that here when the money demand increases you can see that demand for bond demand decreases. So when the bond demand decreases the bond price, price of bond also decreases when the price of bond decreases means rate of interest increases. So in this diagram what we can say that when there is increase in income people demand more money so that means money demand increases then other channel that we mentioned bond demand decrease price of bond increase and rate of interest increase. So then that means we can see that the money demand then the money demand curve will be shifting rightwards. So because of the increase in income at the given rate of interest they should be demanding this much actually that is their money demand but because the increase in money demand and all the point that we discuss here we can see that the curve will be shifting the new demand curve is MDY1 this is the new demand curve. But because of the channel that we discuss here you can see that the rate of interest is increasing and because money supply since the money supply anyway is already fixed is already for example 100 billion for example. So the new point of equilibrium is going to be at point B where you can see that people though they demand more money because they need more money where the demand for money is more at the higher level of income. However because of that the mechanism that we discuss here the rate of interest increase, rate of interest increase is nothing but the opportunity cost of holding money opportunity cost of demanding money increases. So because of that though initially there is a pressure of increase in money demand finally they will be content with whatever they are having that the initial money supply because high increasing money rate of interest increase the opportunity cost. So as a result the money demand will be equal to the initial position. So that means they will be content with the initial money supply that the 100 billion then the money demand also become 100 billion only because of the high rate of interest. That means high rate of interest is required in the money market in order to attain equilibrium high rate of interest is required that means successively higher interest rates that is R0 and R1. So here the rate of interest is required to make money market in equilibrium. Similarly further if there is increase in income to Y2 again the same mechanism they need suppose Y2 is for example 1000 billion you can write like that. So 1000 billion then again the same mechanism holds here then you know that the rate of interest increase then finally money demand is equal to money supply at this point then again the money market is in equilibrium. So what we can see here is that higher the level of income to summarize this points higher the level of income when GDP increases money demand increases however due to increase in rate of interest money demand will be equal to the initial position because equate with the money supply. So the rate of interest increase so importantly in order to ensure in order to become the money market in equilibrium increase in income leads to is required successively higher interest rate at higher levels of income. So because of that we can see that higher the level of income when the GDP increases in order to for the money market equilibrium it requires higher rate of interest. So that means the equilibrium points are like that higher the GDP the rate of interest also increases. So that means at higher levels of income for the equilibrium in the money market the equilibrium combination such as this one points along the LM schedule we can see that as a result higher income requires successively higher rate of interest where money market is in equilibrium that the money demand is equal to money supply. Then accordingly we can see that the LM curve is upward slopping. So the LM curve is upward slopping so just to summarize this one the reason for the positive slope for the LM schedule that means an increase in income increases money demand at a given interest rate. Because transaction demand for money varies positively with income and higher economic activity puts pressure on interest rates. So in order to restore restoring money demand to a level equal to the fixed money supply request the interest rate be higher. The higher interest rate results in a lower speculative demand for money and lower the transaction component corresponding to at any given level of income. The interest rate must rise until this decline in money demand is just equal to the initial income induced increase in transaction demand for money. Let me also show you here this diagram the money supply which we mentioned here this is actually the real balances it should be expressed in real terms that the money supply divided by the price level. This is another way because we are talking about the real money supply that means real money supply M divided by P. So again in order to do that what we say that we also assume that the price level is also fixed. This is another way of presenting that the MS it also can be written as MS that MS divided by the price level. So here our assumption is that money supply is fixed and again the price level is also fixed. So in the next session we will continue this discussion then we will also see what are the factors that affect the shifting of LM curve and subsequently we will also derive the IS schedule and IS curve. Thank you.