Review of the previous lecture 1. Keynesian Cross § basic model of income determination § takes fiscal policy & investment as exogenous § fiscal policy has a multiplied impact on income 2. IS curve. § comes from Keynesian Cross when planned investment depends. negatively on interest rate. § shows all combinations of r and Y that equate planned. expenditure with actual expenditure on goods & services Lecture 16 Aggregate demand – I-B . Instructor: Prof. Dr. Qaisar Abbas Lecture Contents .•. The LM curve, and its relation to - the Theory of Liquidity Preference .•. How the IS-LM model determines income and the interest rate in the short. run when P is fixed .•. Policy analysis with the IS-LM Model The Theory of Liquidity Preference •. Due to John Maynard Keynes •. A simple theory in which the interest rate. is determined by money supply and. money demand . Money Supply . The supply of r (M P). s. real money interest. balances rate. is fixed: .(M P) =M P. s . M/P. M P real money. balances Money Demand .Demand for r (M P). money : rate .(M P). d. = L( r ) . L (r ) . M/P. M P real money. balances Equilibrium .The interest rate r (M P). equate the supply demand : . r1 M P = L( r ) L (r ) . M/P. M P real money. balances How the Fed raises the interest rate . r. interest. increase r, M r2 . r1 L (r ) . M/P. M2 M1 real money. P P balances CASE STUDY. Volcker’s Monetary Tightening.•. Late 1970s: > 10%.•. Oct 1979: Fed Chairman Paul Volcker announced that monetary. policy. would aim to reduce inflation •. Aug 1979-April 1980:. Fed reduces M/P .•. Jan 1983: = . How do you think this policy change . would affect interest rates? Volcker’s Monetary Tightening, cont . The effects of a monetary tightening . on nominal interest rates. short run long run. Quantity Theory, . Liquidity Preference. model Fisher Effect. (Keynesian). (Classical) prices sticky flexible prediction i > 0 i |
