Gross Domestic Product (GDP) is a central concept in macroeconomics, serving as a

fundamental measure of a nation's economic activity. It is formally defined as the market value
of all final goods and services produced within a country during a specific period of time.
This definition contains several key components:

● Market Value: GDP uses market prices to sum up the value of diverse goods and
services produced in monetary terms. This allows for aggregation. However, this
approach excludes nonmarket activities like homemaking or the value of environmental
quality, although some adjustments are made for the underground economy.
Government services not sold in markets are valued at their cost of production.
● Final Goods and Services: To avoid double counting, GDP only includes the market
value of final goods and services. Final goods and services are those purchased by
the final user. Intermediate goods and services are inputs used up in the production of
other goods or services within the same period. Capital goods are considered final
goods because they are not used up in the same period they are produced. Inventory
investment is also treated as a final good. The value-added method inherently avoids
double counting by summing the value added at each stage.
● Currently Produced: GDP measures only goods and services produced within the
specified time period. It excludes transactions involving goods that already exist, such as
the sale of second-hand items. Financial transactions like trading stocks and bonds are
also excluded because they do not represent the production of new assets. Government
transfer payments are excluded as they are not made in return for currently supplied
goods and services.
● Within a Country: GDP focuses on production that takes place within the geographical
borders of the country.

GDP vs. GNP

GDP is often compared to Gross National Product (GNP). While both measure the total market
value of production over a year, they differ in scope.

● GDP is based on production within the country's geographical limits.

● GNP measures the output produced by domestically owned factors of production,
regardless of location. The relationship is defined as GNP = GDP + NFIA (or NFP, Net
Factor Income from Abroad). NFIA represents the income earned by domestic residents
and firms from overseas operations minus the income earned by foreign residents and
firms from domestic operations. For instance, income of Indians working abroad is
included in India's GNP but not its GDP. The sources note that the difference between
GDP and GNP is relatively small for the United States.

Measuring GDP: The Three Approaches

GDP can be measured using three equivalent approaches, reflecting the circular flow of income
and expenditure in the economy. The fundamental identity is that total production = total
income = total expenditure.

1. Production Approach (or Value Added Method): This method sums the value of all
goods and services produced by all sectors in the economy and subtracts the cost of
intermediate goods. This sum represents the gross value added (GVA) by each sector.
GDP is the sum of GVA across all sectors. GDP at Factor Cost can be derived from
 GDP at Market Price by subtracting net indirect taxes (Indirect Taxes minus Subsidies).
This method avoids double counting by only considering the value added at each stage
of production.
2. Expenditure Method: This approach measures the total spending on final goods and
services by different economic agents. The main components are:
○ Consumption (C): Spending by domestic households on final goods and
services, including durables, nondurables, and services.
○ Investment (I): Spending on new capital goods (fixed investment, including
business and residential) plus changes in inventories (inventory investment).
○ Government Purchases of Goods and Services (G): Spending by the
government on goods or services. This excludes transfer payments (like Social
Security or welfare) and interest payments on government debt, as these are not
in exchange for current goods or services.
○ Net Exports (NX): Exports (goods produced domestically and bought by
foreigners) minus imports (goods produced abroad and bought domestically).
Imports are subtracted because they are produced abroad but included in the C,
I, or G categories. The identity for this approach is Y = C + I + G + NX, where Y
represents total expenditure, which equals GDP.
3. Income Method: This method sums the income generated from the production process.
This includes income earned by the factors of production (land, labour, capital, and
entrepreneurship). Components include compensation of employees (wages, salaries,
benefits), proprietors' income, rental income, corporate profits, net interest, and taxes on
production and imports. Summing these gives National Income (NNPFC), and adding
Net Factor Income from Abroad (NFIA) to Net Domestic Product at Factor Cost
(NDPFC) gives National Income (NNPFC). The circular flow diagram illustrates that total
income equals total expenditure.

The sources use the circular flow diagram to show how production, income, and expenditure are
equivalent. Firms produce goods and services and sell them (expenditure). Firms use factors of
production from households, paying them income (income). This income is then used by
households for consumption, saving, and taxes (expenditure).

Real vs. Nominal GDP

A crucial distinction in GDP measurement is between nominal and real GDP.

● Nominal GDP measures the value of final goods and services using current market
prices. Changes in nominal GDP can reflect either changes in the quantities of output or
changes in prices.
● Real GDP measures the value of final goods and services using the prices of a base
year. By holding prices constant, real GDP isolates changes in the quantities of output,
effectively controlling for inflation. Examples are provided to illustrate the calculation of
nominal and real GDP.

Price Indexes and Inflation

Price indexes are used to measure the average level of prices. The GDP deflator is one such
index, defined as (Nominal GDP / Real GDP) * 100. The GDP deflator measures the current
price level relative to the base year, where its value is 100. The GDP deflator is a weighted
average of prices, with weights changing over time to reflect relative importance in GDP.
The inflation rate is the percentage increase in the overall level of prices. It can be calculated
using a price index like the GDP deflator: the inflation rate between period t and t+1 is (Pt+1 –
Pt)/Pt, where P is the price level. An increase in the GDP deflator from 100 to 105 implies a 5%
inflation rate.

Another common price index is the Consumer Price Index (CPI), which measures changes in
the cost of a fixed "basket" of goods and services consumed by a typical household. The
sources compare the CPI and the GDP deflator, highlighting key differences:

● Prices of capital goods: Included in the GDP deflator (if domestically produced) but
excluded from the CPI.
● Prices of imported consumer goods: Included in the CPI but excluded from the GDP
deflator.
● Basket of goods: Fixed for the CPI, but changes every year for the GDP deflator. The
GDP deflator's changing weights make it a chain-weighted index, considered more
accurate than constant-price GDP.

The sources also discuss potential biases in the CPI, suggesting it may overstate inflation.
Reasons include:

● Substitution bias: The fixed weights don't account for consumers substituting away
from goods whose relative prices have risen.
● Introduction of new goods: New goods improve welfare but don't reduce the CPI
because they aren't in the fixed basket.
● Unmeasured changes in quality: Quality improvements increase the value of money
but are often not fully captured. The Personal Consumption Expenditures (PCE) price
index is mentioned as the Federal Reserve's preferred measure, which avoids
substitution bias and is revised with better data.

Limitations of GDP as an Index of Welfare

While GDP is a significant measure of economic activity, the sources explicitly state its
limitations as an index of the welfare or well-being of a country. These limitations include:

● Population: GDP figures don't indicate the size of the population, so high total GDP
might be spread thinly among a large population, resulting in a low standard of living.
● Resources and Area: High national income might be due to a large geographical area
or concentrated resources, not necessarily widespread welfare.
● Price Level: GDP doesn't inherently account for the level of prices; high income might
not translate to a high standard of living if prices are also very high.
● Unemployment: The level of unemployment is not directly captured by GDP figures.
● Ecological Degradation: GDP accounting does not necessarily reflect environmental
damage caused by production.

Furthermore, national income accounting, which includes GDP, omits certain activities:

● Underground activities: Both legal (unreported exchanges) and illegal activities (like
smuggling or bribery) are largely excluded, leading to underestimation.
● Sales of used goods: Excluded because their value was counted when they were
originally produced.
 ● Financial transactions: Excluded as they don't represent the production of new goods
or services.
● Government transfer payments: Excluded as they are not payments for current
production.
● Leisure: Considered a "good" but is difficult to quantify and therefore excluded.
● Non-market activities: Unpaid services, such as those performed by housewives, are
not exchanged for money and thus underestimated in national income.

Difficulties in Measurement

Measuring national income/GDP faces practical difficulties:

● Non-monetary transactions: Activities not exchanged for money are hard to value and
exclude services like unpaid housework.
● Double counting: Failure to distinguish clearly between final and intermediate products
can lead to counting the value of commodities multiple times. This can be avoided by
using the value-added method or counting only the value of final goods.
● Tax evasion: Rampant tax evasion in some countries leads to underestimation of
national income.
● Transfer payments: Difficulties in including transfer payments as they are income to
individuals but government expenditure. They are generally deducted from national
income calculations.
● Depreciation: Estimating the current depreciated value of long-lived capital is
challenging.
● Price changes: Changes in the general price level can distort comparisons of national
income over time; adjustments using index numbers are needed, but these indexes may
not be perfectly accurate.
● Statistical problems: Paucity of accurate and complete statistics, particularly in
developing countries with unorganized production and non-monetised sectors, makes
precise computation difficult.

In conclusion, GDP is a comprehensive measure of economic output, valuable for

understanding economic structure and performance, especially for policy making and analysis.
However, it is essential to be aware of its definition's nuances, the various measurement
methods, and its limitations as a sole indicator of societal welfare or well-being.

Question 1: Explain the fundamental relationship between national saving, domestic

investment, and a country's international economic position, as presented in the sources. How
does this relationship extend to link private saving specifically to investment, government
borrowing, and the current account?

Answer:

The sources establish a crucial macroeconomic identity linking national saving, domestic
investment, and a nation's international economic transactions, specifically the current account.
National saving (S) is defined as the total income of the economy (GNP) minus spending to
satisfy current needs (consumption (C) and government purchases (G)). The identity S = I + CA
shows that a country's national saving is equal to its domestic investment (I) plus its current
account balance (CA). This relationship signifies that national saving is used to finance either
the accumulation of domestic capital (investment) or the acquisition of foreign assets
(represented by a current account surplus).

This core identity can be further broken down to understand the uses of private saving (Spvt).
Private saving is the saving of the private sector, which equals private disposable income minus
consumption. National saving (S) is the sum of private saving (Spvt) and government saving
(Sgovt). Government saving is also known as the government budget surplus; a budget deficit
means government saving is negative (-Sgovt).

By substituting S = Spvt + Sgovt into the identity S = I + CA, the sources derive the uses-of-
private-saving identity: Spvt = I + (–Sgovt) + CA. This powerful identity reveals the three
ways in which private saving is channelled within the economy:

1. Investment (I): Firms borrow from private savers to finance new capital accumulation,
such as the construction and purchase of new equipment, structures, and inventory
investment.
2. The Government Budget Deficit (–Sgovt): When the government runs a budget deficit
(i.e., government saving is negative), it must borrow from private savers to cover the
difference between its outlays and receipts.
3. The Current Account Balance (CA): A positive current account balance means that
foreigners' payments to the domestic country are less than their receipts from the
domestic country. To balance this, foreigners must either borrow from domestic private
savers or sell assets to domestic savers. Conversely, a current account deficit (negative
CA), which the U.S. experienced significantly in past decades, implies that a country's
payments to foreigners exceed its receipts, requiring the country to borrow from
foreigners or sell domestic assets to foreigners, essentially meaning foreigners are using
their saving to finance the deficit.

Therefore, the identities S = I + CA and Spvt = I + (-Sgovt) + CA provide a comprehensive

framework for understanding how saving finances investment, government debt, and
international flows of capital and assets.

Question 2: Compare and contrast the GDP deflator and the Consumer Price Index (CPI) as
measures of the overall price level, highlighting their construction differences and the specific
biases that the sources suggest affect the CPI. How does the existence of these different
measures and biases complicate macroeconomic analysis, particularly when considering
changes in real income or the effectiveness of policy?

Answer:

The sources present both the GDP deflator and the Consumer Price Index (CPI) as measures
of the overall level of prices, but they differ in their construction and the scope of prices they
include.

The GDP deflator is calculated using the formula (Nominal GDP / Real GDP) * 100. Nominal
GDP values current production at current prices, while Real GDP values current production at
base-year prices. The GDP deflator essentially measures the current price level relative to the
price level in the base year. A key characteristic is that the weights given to the prices of
different goods and services in the GDP deflator change every year to reflect the current
composition of goods and services produced domestically. The GDP deflator includes the prices
of all domestically produced final goods and services, including capital goods (if produced
domestically). It excludes the prices of goods and services produced abroad, even if consumed
domestically (i.e., imports).

The Consumer Price Index (CPI), in contrast, tracks the cost of a fixed basket of goods and
services that is typically purchased by urban households. The basket composition is determined
by surveying consumers periodically. The CPI in any given month is calculated by taking the
cost of the basket in that month and dividing it by the cost of the same basket in a chosen base
period, then multiplying by 100. Unlike the GDP deflator, the CPI includes the prices of
imported consumer goods because they are part of the typical consumer's purchases. It
excludes the prices of domestically produced capital goods unless they are directly purchased
by households for consumption (which is rare). The weights for different items in the CPI
basket remain fixed over time until the basket is updated.

The sources highlight that the CPI may overstate inflation. Several factors contribute to this
potential bias:

● Substitution Bias: Because the CPI uses a fixed basket, it does not account for the fact
that consumers tend to substitute away from goods whose relative prices have risen
towards those whose relative prices have fallen. This means the CPI gives too much
weight to goods that have become relatively more expensive.
● Introduction of New Goods: The fixed basket does not immediately incorporate new
goods. The introduction of new goods often improves welfare or provides new value,
which is akin to a decrease in the cost of living, but this is not reflected in the CPI until
the basket is updated.
● Unmeasured Changes in Quality: While the Bureau of Labor Statistics attempts to
adjust for quality changes, it is difficult to perfectly measure improvements in the quality
of goods and services. If quality improvements are not fully accounted for, a price
increase for a higher-quality good might be registered as pure inflation, overstating the
true increase in the cost of obtaining the same level of satisfaction.

The existence of these different price measures and the potential biases in the CPI significantly
complicate macroeconomic analysis. When considering changes in real income or the
standard of living, using an inflation measure that overstates price increases (like the CPI
might) could lead to an underestimation of the growth in real income. Policies or contracts that
are indexed to the CPI (like Social Security payments) might be over-indexed, meaning
payments rise faster than the true cost of living, which has implications for government budgets
and the real value of transfers. Furthermore, policymakers like the Federal Reserve need to
choose which price index is the most appropriate for monitoring inflation and making policy
decisions; the sources note that the Fed prefers the Personal Consumption Expenditures (PCE)
price index partly because it avoids the substitution bias inherent in the CPI. The choice of index
affects the measured inflation rate and can influence the perceived success or failure of anti-
inflationary policies.

Question 3: GDP is a primary measure of economic activity, but the sources list several
limitations to using it as an index of welfare. Detail these limitations, providing examples from
the sources, and explain why they represent shortcomings in GDP as a comprehensive welfare
metric.

Answer:
While Gross Domestic Product (GDP) is a crucial measure of the market value of goods and
services produced within a country, the sources explicitly caution against using it as a sole or
complete index of a nation's welfare or standard of living. The limitations stem from what GDP
inherently measures (market production) and what it omits or fails to account for.

Several key limitations are highlighted:

1. Exclusion of Non-Market Activities: GDP only measures goods and services

exchanged in market transactions. This means valuable production and services that
occur outside of formal markets are excluded. Examples given include housekeeping
and child-rearing services performed by family members and vegetables grown in
the backyard of a house. The unpaid service of housewives, for instance, contributes
significantly to household well-being and productivity but is not reflected in GDP, leading
to an underestimation of national income.
2. Exclusion of Sales of Used Goods and Financial Transactions: GDP measures only
currently produced goods and services. The sale and purchase of second-hand goods
(like used cars or houses) are excluded because their value was counted in the GDP of
the period in which they were originally produced. Similarly, financial transactions such
as the trading of stocks and bonds are not included because they represent the
exchange of existing assets or claims, not the production of new goods or services.
While these transactions are economically significant, their exclusion means GDP
doesn't capture all forms of economic activity that affect wealth or financial stability.
3. Exclusion of Government Transfer Payments: Government transfer payments, such
as Social Security, welfare, and unemployment benefits, are not included in GDP. These
are payments made without a corresponding exchange for currently supplied goods or
services; they represent a redistribution of existing income. While these payments
contribute to the income and welfare of recipients, they do not reflect new production, so
including them would not align with GDP's definition.
4. Ignoring the Underground Economy and Illegal Activities: Economic activities that
take place outside normal, recorded market channels, including both legal but
unreported exchanges (like cash payments to avoid taxes) and illegal goods and
services (like cocaine or gambling), are generally excluded from GDP measurement.
While efforts may be made to adjust for the underground economy, their exclusion
means GDP does not capture the full scope of economic transactions, impacting its
accuracy and its reflection of all income-generating activities.
5. Failure to Account for Leisure: Leisure is considered a valuable good by the sources,
similar to cars or houses. However, unlike produced goods, it is too difficult to quantify
and is thus not counted in GDP. An increase in leisure time could significantly improve
welfare, but a GDP measure focused purely on production might fail to reflect this gain.
6. No Indication of Distribution of Income/Resources: High national income or GDP
figures provide no information about how income, skills, or resources are distributed
among the population. A country might have high total GDP, but if the income is
concentrated among a small percentage of the population, the welfare of the average
person might be low. GDP does not reflect inequality.
7. Doesn't Adjust for Population Size: Total national income figures do not account for
the population size of the country. A large country may have a higher total GDP simply
due to having more people, but this doesn't mean the standard of living per person is
higher. Comparing GDP per capita is necessary for a better sense of average living
standards, but the total GDP figure itself is insufficient.
8. Ignores the Price Level: High nominal GDP might not translate to a high standard of
living if the general price level is also very high. Real GDP, which adjusts for prices,
 provides a better measure of production volume, but even this doesn't fully capture
welfare in the face of price volatility or high absolute price levels.
9. Doesn't Account for Unemployment: The level of unemployment, a critical factor
affecting individual and societal welfare, is not directly taken into account by GDP. A
country could experience a significant increase in unemployment while GDP remains
relatively stable (due to increased productivity of those employed), masking a decline in
overall well-being.
10. Disregard for Ecological Degradation: GDP measurement does not inherently
consider the environmental costs or benefits associated with economic production.
Activities that contribute positively to GDP (e.g., resource extraction, manufacturing)
might simultaneously cause ecological degradation (e.g., pollution, deforestation),
reducing overall welfare, a factor not captured by GDP.

These limitations mean that while GDP is an excellent tool for measuring market-based
production and economic activity, it provides an incomplete and potentially misleading picture
when used as a sole measure of the broader well-being or welfare of a nation's residents. Other
metrics and analyses are required to understand aspects like income distribution, environmental
quality, health, education, and leisure, which are also critical components of a nation's welfare.
Introduction to Money and Inflation
The discussion about money begins by looking at inflation.

● The inflation rate is defined as the percentage increase in the average level of prices.
● A price is the amount of money required to buy a good.
● Because prices are defined in terms of money, understanding the nature of money, its
supply, and how it is controlled is necessary.
● A chart shows the trend of U.S. inflation from 1960 to 2010, measured as the percentage
change in the CPI from 12 months earlier. The chart displays fluctuations over this
period, with a prominent peak around the late 1970s/early 1980s.

Asset Markets
An asset market refers to the entire set of markets where people buy and sell real and financial
assets. Examples include markets for gold, houses, stocks, and bonds.

What is Money?
Money is a type of asset that holds special macroeconomic significance.

● In economics, money is the term for assets that can be readily used in making
payments. Examples include cash and savings/checking accounts.
● Money is defined as the stock of assets that can be readily used for transactions.
● It is important to note that in economics, money refers specifically to assets that are
widely used and accepted as payment, unlike common usage where "money" might
mean income or wealth.
● Historically, money has taken various forms, such as beads, shells, gold, silver, and
even cigarettes.

Types of Money
The sources identify two main types of money:

1. Fiat money: This type of money has no intrinsic value. The paper currency we use is
an example.
2. Commodity money: This type of money has intrinsic value. Examples include gold
coins and cigarettes in prisons.

Functions of Money
Money performs several important functions:

● Medium of exchange: Money is used to buy things.

● Store of value: Money transfers purchasing power from the present to the future.
● Unit of account: Money is the common unit used by everyone to measure prices and
values.
● Standard of deferred payment: Money units are used in long-term transactions, such
as the repayment of loans.
Money Supply and Monetary Policy
● The money supply is the quantity of money available in the economy.
● In modern economies, the money supply is determined by the central bank.
● Monetary policy is the control over the money supply.

The Central Bank

● Monetary policy is conducted by a country's central bank.
● Examples of central banks include the Reserve Bank of India (RBI) in India, the
European Central Bank (ECB) in the EU zone, and the Federal Reserve ("the Fed") in
the U.S..

Measuring Money: Monetary Aggregates

Because assets differ in their "moneyness" or liquidity, no single measure of the money stock is
completely satisfactory. Economists and policymakers in most countries use several different
measures, known as monetary aggregates.

● Money supply measures in the US (September 2013):

○C: Currency ($1135 billion).

○M1: Includes C + demand deposits, travellers' checks, and other checkable
deposits ($2535 billion).
○ M2: Includes M1 + small time deposits, savings deposits, money market mutual
funds, money ($10703 billion). M2 includes less liquid assets than M1.
● Measures of money supply in India:

○ The Reserve Bank of India (RBI) has developed four alternative measures: M1,
M2, M3, and M4. The RBI collects and publishes figures for all four measures.
○ Money Supply is the total stock of money circulating in an economy on a
specific day. This includes notes, coins, and demand deposits held by the public.
○ Money supply is a stock variable.
○ Importantly, money kept with the government, central bank, etc., is NOT included
in the money supply as it is not in actual circulation.
○ M1 (Narrow Money): Includes all currency notes held by the public + all demand
deposits (savings and current) with banks + other deposits of banks kept with the
RBI. So, M1 = CC + DD + Other Deposits.
○ M2: Includes M1 + savings deposits of post office banks. So, M2 = M1 + Savings
Deposits of Post Office Savings.
○ M3 (Broad Money): Includes all currency notes held by the public + all demand
deposits with banks + deposits of all banks with the RBI + the net Time Deposits
of all banks. So, M3 = M1 + time deposits of banks.
○ M4: The widest measure used by the RBI. It includes M3 + savings of post office
banks. M4 is the least liquid measure. So, M4 = M3 + Post office savings.

Sources of Money Supply (in India)

There are three main sources of money supply in the economy, which are responsible for
production and distribution:
 1. The government: Produces all coins and one-rupee notes.
2. The Reserve Bank of India (RBI): Issues all paper currency.
3. Commercial banks: Create credit in the form of bank deposits based on demand
deposits. Most money in the economy (97%) exists as bank deposits created by banks
making loans, while only 3% is physical cash.

Demand for Money

● The demand for money is the total amount of money the population wants to hold.
● The discussion often simplifies the choice to holding money or bonds.
● Money (currency and checkable deposits - M1) can be used for transactions but
typically pays no interest.
● Bonds pay a positive interest rate (i) but cannot be used for transactions.

Demand for Real Money Balances

● The demand for money is a demand for real money balances.
● People are concerned with the purchasing power of their money rather than just the
nominal amount.
● The demand for real balances depends on:
○ Real income: People hold money for purchases, which depend on income.
Higher real income leads to higher demand for real balances.
○ Interest rate: The interest rate is the cost of holding money (the return forgone
by not holding bonds). A higher interest rate makes holding money more
expensive, reducing the amount held at any given income level.

Classical vs. Keynesian Theories of Money Demand

There is a difference in the theory of demand for money between the Classical and Keynesian
models.

● Classical Model:

○ The first attempt to explain macroeconomic variables like inflation, output,

income, employment, etc..
○ Assumes pure competition, flexible wages and prices, self-interest, no money
illusion (people understand nominal vs. real value), and temporary self-correcting
economic problems.
○ Assumes a world of fully utilized resources.
○ According to the Classical model, only the transactions motive for holding
money exists; people hold money solely for transactions.
○ It rejects the store of value theory, arguing that a rational person would not hold
non-interest-bearing money if they could earn a return on bonds, unless for a
planned transaction. Therefore, people do not hoard money.
○ In the Quantity Theory of Money (QTM) framework (Classical), the rate of
interest does NOT affect the demand for money.
○ Under the Classical model, money is seen purely as a medium of exchange and
is demanded only for transaction purposes. The alternative to holding money is
buying goods/services.
 ○ The demand and supply of money do not determine the rate of interest in the
classical system.
○ As a result, monetary policy is seen as unable to stimulate the economy in the
Classical model.
● Keynesian Model:

○ Developed by J.M Keynes to explain economic decline (like the 1930s

depression) that the Classical model couldn't.
○ Keynes argued that wages and prices are inflexible or "sticky" downwards, partly
due to factors like labour unions and minimum wage laws.
○ This has implications for aggregate demand and the government's role.
○ Keynes used the term "liquidity preference" for the demand for money.
○ He suggested three motives for demanding money:
1. Transactions motive: Arises because money is needed for regular
payments and there is a lack of synchronization between receiving and
spending money. The magnitude of this demand depends on the level of
income; higher income means greater demand for transaction balances.
Holding money for transactions means foregoing interest. Money for
transactions is currency and checkable deposits.
2. Precautionary motive: Holding money to deal with unexpected
contingencies and spending needs. This also depends on income level;
higher income leads to holding more money for precaution. For both
transactions and precautionary demand, a rise in interest rates increases
the opportunity cost of holding money.
3. Speculative motive: Holding wealth in assets like property, bonds,
money, or gold. Simplifying, Keynes considered two assets: money (no
return) and bonds (yield a return). Money is demanded as a 'store of
wealth'. If the bond market is unfavourable or expected to decline,
investors may hold cash balances to wait for better conditions; this is
speculative demand. Speculative demand for money is inversely related
to the rate of interest. When interest rates are high, people prefer
investing in bonds; when low, they prefer holding money.
○ The proportions of money and bonds people hold depend mainly on: 1) the level
of transactions (affecting transaction demand) and 2) the interest rate on bonds
(affecting speculative demand).
○ The Keynesian theory implies that monetary policy can be used to stimulate the
economy and increase GDP and employment.

Factors Affecting Demand for Money (Keynesian View)

● The demand for money (Md) is a function of nominal income ($Y) and the interest rate
(i). The relationship is expressed as: Md = $Y L(i), where L(i) represents the negative
relationship with the interest rate.
● For a given nominal income, a lower interest rate increases the demand for money.
● At a given interest rate, an increase in income shifts the demand for money curve to
the right.

Liquidity Trap
 ● A liquidity trap is a situation with a very low interest rate where economic agents expect
the rate to rise.
● In this situation, everyone holds their wealth in money, and the speculative demand for
money is infinite.
● The sources note that in such a situation, monetary policy is ineffective.
● However, if investors still hold bonds when interest rates are low (near zero), it is not a
liquidity trap.

Related Economic Concepts

● Income: What you earn from work, interest, and dividends. It is a flow (expressed per
unit of time).
● Saving: The part of after-tax income not spent. It is also a flow.
● Wealth: Accumulated savings. It is the value of financial assets minus financial liabilities.
Wealth is a stock variable (measured at a point in time).
● Investment: Purchase of new capital goods (e.g., machines, plants). The purchase of
stocks or other financial assets is financial investment.

Quantity Theory of Money (QTM)

The QTM is the Classical theory of money demand.

● It is a framework to understand price changes relative to the money supply.

● Economist Irving Fisher is credited with developing this theory.
● A later version, the Cambridge version, focused on QTM as a theory of money
demand.

Fisher's Version: Equation of Exchange

● The QTM begins with the equation of exchange: MV = PY.

○ M = money supply.
○ V = velocity of money (average number of times a dollar is spent per year).
○ P = price level.
○ Y = aggregate output (real income).
○ P x Y = total spending on final goods/services (nominal income or nominal GDP).
● Velocity can be defined as V = (P x Y) / M.

Fisher's Assumptions for QTM

Fisher makes two key Classical assumptions:

1. Velocity of money (V) is constant in the short run. This is because factors affecting
velocity (institutions, technology, payment habits) change slowly.
2. Full-employment output (Y) is constant in the short run. Classical economists
believed flexible wages and prices ensured output is always at its full-employment level.

QTM Outcome (Fisher's Version)

● With V and Y constant, the equation MV = PY implies that changes in money supply
(M) only affect the price level (P).
 ● A 1% increase in the money supply leads to a 1% increase in the average level of
prices.
● The basic result of the QTM is that the quantity of money determines the price level.
● QTM provides the foundation for the Classical view that money supply does not affect
real output or employment.

The Cambridge Approach to QTM

● This approach aims to explain the economic logic behind the proportionality between
money supply and prices.
● Cambridge economists (like Marshall) assumed the demand for money (Md) would be
a proportion (k) of nominal income (PY).
● The Cambridge equation is Md = kPY.
● The logic is that money is useful for transactions, so demand depends on the level of
transactions, which is closely related to income.
● The proportion k is assumed stable in the short run, depending on payment habits,
similar to V in Fisher's formula.
● In equilibrium, money supply (Ms) equals money demand (Md): Ms = Md = k x PY.
● With k fixed and Y at full-employment, the Cambridge equation also shows a
proportional relationship between the price level and money supply.

Equivalence of the Approaches

● The Cambridge equation Md = kPY can be rewritten as Md (1/k) = PY.

● Comparing this to Fisher's MV = PY, we see that V = 1/k.
● Holding 1/4 of nominal income as money (k=1/4) means the average dollar is used 4
times in income transactions (V=4).
● While formally equivalent, the Cambridge version is seen as a step towards more
modern monetary theories by focusing on the QTM as a theory of the demand for
money.

QTM and Money Demand Conclusion

According to QTM:

● Interest rates have no impact on the demand for money.

● High money supply growth leads to inflation.
● Low or contracting money supply growth leads to deflation.
● A stable economy requires controlled money supply growth that matches the economy's
long-run growth rate.

Determination of the Interest Rate

The interest rate is determined by the equality of money supply and money demand in the
financial markets.

● Initially, assuming only currency exists (no checkable deposits), the equilibrium condition
is Ms = Md.
● Substituting the money demand function, the equilibrium is: M = $Y L(i).
● This equation states the interest rate (i) must be such that, given nominal income ($Y),
people are willing to hold the existing money supply (M).
LM Relation

● This equilibrium relation (M = $Y L(i)) is called the LM relation.

● 'L' stands for liquidity (how easily an asset is exchanged for money; money is fully
liquid). Demand for money is demand for liquidity.
● 'M' stands for money.
● Equilibrium in the money market requires the demand for liquidity to equal the supply of
money.

Supply and Demand for Money Curves

● In a graph with money on the horizontal axis and interest rate on the vertical axis, the
money supply (Ms) is a vertical line because the central bank determines it
independently of the interest rate.
● The demand for money (Md) is downward sloping. A higher interest rate reduces
money demand as people prefer to invest in bonds. Md is drawn for a given level of
nominal income ($Y).
● Equilibrium occurs at the intersection of the Ms and Md curves [47, Figure 1].

Effects on the Interest Rate

● Increase in Income: An increase in nominal income ($Y) increases transactions,

shifting the money demand curve (Md) to the right. The equilibrium moves up along the
vertical money supply curve, leading to an increase in the equilibrium interest rate
[48, Figure 2].
● Increase in Money Supply: An increase in the money supply (Ms) by the central bank
shifts the money supply curve (Ms) to the right. The equilibrium moves down along the
money demand curve, leading to a decrease in the equilibrium interest rate [49,
Figure 3].

How the Central Bank Changes Money Supply

The standard method central banks use to change the money stock is open-market
operations. These involve the purchase and sale of government bonds in the "open market".

● Expansionary Open Market Operation (Easy Money Policy): The central bank buys
bonds. This increases (expands) the money supply. Buying bonds increases bond
prices, which leads to a decrease in the rate of interest. This encourages investment,
increasing income (GDP) and employment. This is called expansionary monetary
policy.
● Contractionary Open Market Operation (Tight Money Policy): The central bank sells
bonds. This decreases (contracts) the money supply. Selling bonds decreases bond
prices, which leads to an increase in the rate of interest. By selling bonds in exchange
for money previously held by households, the central bank reduces the money supply.
Central banks use contractionary policy to mop up excess liquidity and control inflation.

Bond Prices and Bond Yields (Interest Rate)

● Government bonds (like Treasury bills) promise payment in a year or less.

● The rate of return (interest) on a $100 bond bought today (at price $PB) and held for a
year is ($100 - $PB)/$PB.
 ● This formula shows a negative/inverse relationship between bond prices and the
rate of interest. When bond prices rise, the interest rate falls, and vice versa.

Choosing Money Supply or Interest Rate

● The central bank can either choose the money supply and let the interest rate be
determined, or choose the interest rate and adjust the money supply to achieve that
rate.
● A central bank decision to lower the interest rate is equivalent to increasing the money
supply [54, Figure 3].
● Changing the money supply and changing the interest rate are seen as different tools of
monetary policy.

What Banks Do
● Financial intermediaries are institutions acting as middlemen between two parties to
facilitate a financial transaction. Examples include commercial banks, investment banks,
mutual funds, and pension funds.
● A bank is a financial intermediary licensed to accept public deposits and give loans.
● Banks receive funds from people/firms via deposit or current accounts. The value of
these checkable deposits represents the bank's liabilities.
● Banks keep some received funds as reserves.

Why Banks Hold Reserves

Banks hold reserves for three reasons:

1. To meet daily cash withdrawals by depositors.

2. To cover net outflows from checks written by depositors to people at other banks.
3. To comply with reserve requirements imposed by the central bank. The actual reserve
ratio (reserves/checkable deposits) in the U.S. is about 10%.

Assets and Liabilities

● For commercial banks, loans represent about 70% of assets, and bonds about 30%.
● For the Central Bank, assets are the bonds it holds. Liabilities are the money it has
issued, called central bank money (or High-powered Money, H).
● Central bank money is held partly as currency by the public and partly by commercial
banks as reserves (either within the bank or with the central bank).

Supply and Demand for Central Bank Money

● The demand for central bank money (Hd) is the sum of the demand for currency by
the public (CUd) and the demand for reserves by banks (Rd). So, Hd = CUd + Rd.
● The supply of central bank money (H) is directly controlled by the central bank.
● The equilibrium interest rate is determined where the demand for central bank money
equals the supply of central bank money: H = Hd [60, 75, Equation 9].

Money Creation
Money creation is the process by which a country's money supply is increased.
 ● The Central Bank directly controls the monetary base (High-Powered Money, H). This
is the main way the central bank influences the money supply.
● However, the total money supply (M) in the economy is much larger than H. M is linked
to H via the money multiplier. The money multiplier is greater than 1.
● In modern economies, most of the money supply (about 97%) is created by
commercial banks through bank deposits.
● Banks create new money whenever they make loans. This created money is electronic
deposit money, not physical cash. Every new loan creates new money.

Fractional Reserve Banking

● Money creation is determined by the amount banks keep in reserve.

● Fractional reserve banking is the system where banks hold only a fraction of customer
deposits as reserves.
● The crucial assumption is that not all customers will request their money back
simultaneously.
● This allows banks to lend out the rest of the deposits, thereby essentially creating new
money.
● Deposits received but not lent out are called reserves.

100% Reserve Banking (Counterexample)

● In a hypothetical 100% reserve banking system, banks accept deposits and keep the
entire amount in reserve until withdrawal or check is made. All deposits are held in
reserve.
● In this system, the banking system does NOT affect the supply of money; banks do
not create money.

Fractional Reserve Banking Process (Example)

● Suppose a bank has a 20% reserve requirement.

● A customer deposits $100 in Bank A.
● Bank A keeps 20% ($20) as reserve and loans out 80% ($80).
● The recipient of the $80 loan deposits it into Bank B.
● Bank B keeps 20% ($16) as reserve and loans out 80% ($64).
● This process continues, with decreasing amounts being deposited and loaned in
successive rounds, until no more money can be deposited and loaned out.

Calculating Money Created (Simple Multiplier)

● In the example, the initial $100 deposit led to subsequent loans and deposits.
● The total amount of money created from the initial deposit can be calculated by dividing
the initial deposit by the reserve requirement ratio.
● From the example: Money created = $100 / 0.20 = $500.

The Simple Money Multiplier

● The simple money multiplier is given by 1 / Reserve Requirement Ratio.

● For the example with a 20% reserve requirement (0.20), the multiplier is 1 / 0.20 = 5.
The initial $100 deposit, multiplied by 5, gives the total created money of $500.
 ● A higher reserve requirement leads to a lesser multiplier effect and thus less money
created.
● The simple formula (Money created = Initial deposit / Reserve requirement ratio) can be
rearranged to find the required deposit for a target amount of money created: New
deposit = Money created x Reserve requirement ratio. For example, to create
$100,000 with a 5% reserve requirement, a new deposit of $100,000 x 0.05 = $5,000 is
needed.

Demand for Money (Detailed)

● The overall money demand equation is still Md = $Y L(i). People hold more money with
higher transactions and lower interest rates on bonds.
● People also decide how much to hold in currency (CU) and how much in checkable
deposits (D).
● Currency is convenient for small or illegal transactions. Checks/deposits are convenient
for large transactions and safer than cash.
● Assuming people hold a fixed proportion (c) of their money as currency and (1-c) as
deposits:
○ Demand for currency: CUd = cMd [72, Equation 2].
○ Demand for checkable deposits: Dd = (1 - c)Md [72, Equation 3].

Demand for Reserves by Banks

● The demand for checkable deposits leads to a demand for reserves by banks.
● Let θ be the reserve ratio (reserves held per dollar of checkable deposits).
● If people demand Dd in deposits, banks must hold θDd in reserves (R). So, R = θDd [74,
Equation 4].
● Combining this with the demand for deposits (Equation 3), the demand for reserves by
banks (Rd) is: Rd = θ (1 - c) Md [74, Equation 5].

Demand for Central Bank Money (Detailed)

● The demand for central bank money (Hd) is the sum of currency demand (CUd) and
reserve demand (Rd). Hd = CUd + Rd [75, Equation 6].
● Substituting the expressions for CUd (Equation 2) and Rd (Equation 5) gives: Hd = cMd
+ θ (1 - c) Md = [c + θ (1 - c)] Md [75, Equation 7].
● Finally, substituting the overall money demand (Md = $Y L(i)) into Equation 7 yields the
demand for central bank money as a function of income and the interest rate: Hd = [c +
θ (1 - c)] $Y L(i) [75, Equation 8].
● Equilibrium in the market for central bank money determines the interest rate where
supply (H) equals demand (Hd): H = [c + θ (1 - c)] $Y L(i) [75, Equation 9]. The
equilibrium interest rate equates the supply and demand for central bank money.

Alternative View: Equilibrium in the Market for Reserves

● Instead of focusing on central bank money, equilibrium can be viewed in terms of the
supply and demand for bank reserves.
● The supply of reserves equals the supply of central bank money (H) minus the demand
for currency by the public (CUd). Supply of reserves = H - CUd.
● The demand for reserves by banks is Rd.
 ● Equilibrium in the reserve market requires: H - CUd = Rd. Rearranging this gives H =
CUd + Rd, which is the same as the equilibrium condition for central bank money (H =
Hd).

Federal Funds Rate (United States)

● This alternative view is relevant because the U.S. has an actual market for bank
reserves called the federal funds market.
● In this market, banks with excess reserves lend them to banks with insufficient reserves.
● The interest rate determined in this market is the federal funds rate.
● In equilibrium, the total demand for reserves by all banks (Rd) equals the supply of
reserves (H - CUd).
● The Fed can influence the federal funds rate by changing the supply of central bank
money (H) through open-market operations.
● To decrease the federal funds rate, the Fed buys government securities from banks.
This increases the banks' cash reserves, increasing the supply of reserves in the federal
funds market and lowering the rate.
● To increase the federal funds rate, the Fed sells government securities to banks.
● The federal funds rate is the major tool the Fed uses for monetary policy in the United
States, receiving significant public attention.

Supply of Money and the Money Multiplier (Detailed)

● The overall supply of money (M) is equal to central bank money (H) multiplied by the
money multiplier.
● This can be seen by rearranging the equilibrium condition for central bank money
(Equation 9) to solve for Md (which equals M in equilibrium) [81, Equation 8].
● Starting with H = [c + θ (1 - c)] Md, we get: Md = M = [1 / (c + θ (1 - c))] H.
● High-powered money (H) is the term used because the overall money supply ultimately
depends on it.
● The term m = 1 / (c + θ (1 - c)) is the money multiplier. Since (c + θ (1 - c)) is less than
1, its inverse (the multiplier) is greater than 1.
● The overall supply of money equals central bank money times the money multiplier. If
the multiplier is 4, the money supply is 4 times the central bank money supply.

Factors Affecting the Money Multiplier

The money multiplier (m = 1 / (c + θ (1 - c))) depends on:

● The reserve ratio (θ): The money multiplier is larger when the reserve ratio (θ) is
smaller.
● The currency-deposit ratio (c): The money multiplier is larger when the currency-
deposit ratio (c) is smaller. A smaller 'c' means a lesser proportion of high-powered
money is held as currency (outside banks) and a larger proportion is available for banks
to hold as reserves, fueling the credit creation cycle.
● Payment habits of the public determine 'c', affected by the cost and convenience of
getting cash (e.g., ATM availability lowers 'c'). 'c' also has seasonal patterns (higher
around festivals). Households can change 'c', altering the multiplier.
● Banks holding excess reserves (reserves above the requirement θ) also affect the
multiplier. If banks change their excess reserves, the multiplier changes.
Volatility of Money Growth

● Money growth can be volatile because bank demands for reserves and public demand
for currency (which determine 'c' and excess reserves) fluctuate significantly month-to-
month.
● This means the demand for high-powered money changes.
● A central bank aiming to stabilize the money stock must therefore make changes in the
monetary base (H) from time to time.

Bank Runs
● Rumours that a bank is in trouble can cause depositors to simultaneously try to withdraw
their funds, potentially leading to a bank run. If enough people withdraw, the bank runs
out of reserves.
● To avoid bank runs, the U.S. government provides federal deposit insurance.
● An alternative solution suggested is narrow banking, where banks would be restricted
to holding only liquid, safe government bonds (like T-bills). However, this could
negatively impact bank profitability and the interest depositors earn.

Why are we beginning our discussion about money by looking at inflation first? The
discussion begins with inflation because there is a connection between money and prices. The
inflation rate is defined as the percentage increase in the average level of prices. A price is the
amount of money required to buy a good. Since prices are defined in terms of money, it is
necessary to consider the nature of money, its supply, and how it is controlled.

What is an asset market? An asset market refers to the entire set of markets where people
buy and sell real and financial assets. Examples of these assets include gold, houses, stocks,
and bonds.

What is money? Money is a type of asset that holds special macroeconomic significance. It is
defined by economists as assets that can be readily used for making payments or transactions.
Examples given are cash and savings/checking accounts. In economic terms, money
specifically refers to assets that are widely used and accepted as payment. Historically, the
forms of money have varied widely, from beads and shells to gold, silver, and even cigarettes.
Money is the stock of assets that can be readily used for transactions.

It is important to note the economic definition differs from common usage where 'money' might
refer to income or wealth.

What are the types and functions of money? The sources list two types of money:

1. Fiat money: This type has no intrinsic value. The paper currency used today is an
example.
2. Commodity money: This type has intrinsic value. Examples include gold coins and
cigarettes in prisons.

The sources list four functions of money:

● Medium of exchange: Money is used to buy things.

 ● Store of value: Money transfers purchasing power from the present to the future.
● Unit of account: Money is the common unit used by everyone to measure prices and
values.
● Standard of deferred payment: Money units are used in long-term transactions, such
as loan repayments.

How is money supply measured? Economists and policymakers use several different
measures of the money stock, known as monetary aggregates, because assets vary in their
'moneyness' or liquidity. No single measure is considered completely satisfactory.

In the US (as of September 2013), measures mentioned include:

● C (Currency): Physical currency.

● M1: Includes C + demand deposits, travellers’ checks, and other checkable deposits.
● M2: Includes M1 + small time deposits, savings deposits, money market mutual funds,
and money market deposit accounts.

In India, the Reserve Bank of India (RBI) uses four alternative measures of money supply.
Money supply is defined as the total stock of money in circulation in an economy on a specific
day, including notes, coins, and demand deposits held by the public. Money held by the
government or central bank is not included as it is not in actual circulation. The four measures
used by the RBI are:

● M1 (Narrow Money): Includes currency notes held by the public + demand deposits with
all banks (savings and current) + other deposits of banks with the RBI. Formula: M1 =
CC + DD + Other Deposits.
● M2: Includes M1 + savings deposits of the post office banks. Formula: M2 = M1 +
Savings Deposits of Post Office Savings.
● M3 (Broad Money): Includes M1 + net Time Deposits of all banks. Formula: M3 = M1 +
time deposits of banks.
● M4: Includes M3 + savings of the post office banks. It is the widest measure and
considered the least liquid. Formula: M4 = M3 + Post office savings.

What are the sources of money supply? There are three main sources of money supply in an
economy, considered the producers responsible for distribution:

● The government, which produces all coins and one-rupee notes.

● The Central Bank (e.g., RBI in India, ECB in the EU, the Fed in the US), which issues all
paper currency.
● Commercial banks, which create credit through demand deposits. Most money today
(97%) exists as bank deposits, created by banks when they make loans (only 3% is
physical cash).

What is the demand for money? The demand for money is the total amount of money that the
population of an economy wants to hold. The demand is for real money balances, meaning
people are concerned with how much their money can buy (purchasing power), not just the
nominal amount.

The demand for real balances depends on:

● Real income: People hold money for purchases, which depend on income.
 ● Interest rate: This represents the cost of holding money. A higher interest rate makes
holding money more expensive, leading to less cash being held at each income level.

What are the classical and Keynesian theories of money demand? There is a difference in
the theory of demand for money between the Classical and Keynesian models.

● Classical Model: This was an early framework explaining economic factors. Classical
economists assumed pure competition, flexible wages and prices, self-interest, no
money illusion (people understand nominal vs real value), and that economic problems
were temporary and self-correcting. Their world assumed fully utilized resources. In the
Classical model, only the transactions motive for holding money exists. People hold
money solely to make transactions. The theory rejects the store of value motive, arguing
that money bears no interest, and a rational person would not forego a positive return by
holding money unless planning a transaction; thus, people do not hoard money.
According to this view, the interest rate does NOT affect the demand for money.

● Keynesian Model: Developed by J.M Keynes, partly because the Classical model could
not explain the economic decline of the 1930s. Keynes argued that wages and prices
were not fully flexible, particularly downwards ("sticky"), partly due to factors like labor
unions or minimum wage laws. Keynes used the term "liquidity preference" for the
demand for money. He suggested three motives for holding money:

1. Transaction motive: Holding money for regular payments due to the timing
mismatch between receiving and spending money. This demand depends
positively on income.
2. Precautionary motive: Holding money for unexpected contingencies and future
spending needs. This also depends positively on income.
3. Speculative motive: Holding money as a store of wealth, especially when bond
market conditions are unfavorable or expected to worsen. This demand is
inversely related to the interest rate; high rates encourage bond investment, low
rates encourage holding money. In the Keynesian model, the choice between
holding money and bonds depends mainly on the level of transactions (for
transaction demand) and the interest rate on bonds (for speculative demand).
Money ($YL(i)) is a function of income ($Y) and the interest rate (i). For a given
income, a lower interest rate increases money demand. At a given interest rate,
an increase in income shifts the demand for money to the right.

What is the Quantity Theory of Money (QTM)? The Quantity Theory of Money (QTM) is a
framework, originating from the Classical theory, used to understand price changes in relation to
the money supply. Irving Fisher is credited with its development. The Cambridge version of
QTM focused on it as a theory of money demand.

The QTM begins with the equation of exchange: MV = PY.

● M = money supply
● V = velocity of money (average number of times a dollar is spent per year)
● P = price level
● Y = aggregate output (real income)
● PY = total spending on final goods and services (nominal income or nominal GDP)

Fisher's QTM makes two key classical assumptions:

 1. Velocity of money (V) is constant in the short run, as it's affected by slow-changing
factors like institutions, technology, and payment habits.
2. Aggregate output (Y) is constant at the full-employment level in the short run, due to
flexible wages and prices.

With V and Y assumed constant, the QTM concludes that changes in the money supply (M)
affect only the price level (P). Money supply does not impact real output or employment. A 1%
increase in M leads to a 1% increase in P. The basic result of QTM is that the quantity of
money determines the price level. This is the foundation for the Classical view of money's
relationship with the economy.

The Cambridge approach explains this by assuming money demand (Md) is proportional (k) to
nominal income (PY): Md = kPY. The proportion k is considered stable in the short run. In
equilibrium, Ms = Md, so Ms = kPY. With k and Y fixed, this also shows a proportional link
between Ms and P. The Cambridge equation is formally equivalent to Fisher's equation, with V
= 1/k. The Cambridge approach is seen as a step towards modern theories by focusing on
money demand.

In summary, according to the QTM, interest rates have no impact on money demand. High
money supply growth causes inflation, low growth causes deflation. A stable economy requires
controlled money supply growth matching long-run economic growth. This implies money is
neutral in the Classical model, only serving as a medium of exchange, and monetary policy
cannot stimulate the economy.

What determines the rate of interest? The rate of interest is determined by the equality of the
supply of money and the demand for money. Initially assuming only currency exists, the
equilibrium condition is that the money supply (Ms) equals the money demand (Md). This
means the interest rate (i) must adjust such that, given income ($Y), people are willing to hold
the existing money supply (M). This relationship is known as the LM relation. The demand for
money is seen as a demand for liquidity.

The central bank determines the money supply, which is considered independent of the interest
rate. The interest rate is found at the intersection of the downward-sloping money demand curve
(Md, drawn for a given nominal income) and the vertical money supply curve (Ms). A higher
interest rate reduces money demand as people prefer bonds.

● An increase in nominal income ($Y) increases transactions, shifting the money demand
curve to the right, leading to a higher equilibrium interest rate.
● An increase in the money supply (Ms) by the central bank shifts the money supply curve
to the right, leading to a lower equilibrium interest rate.

How does the central bank change the money supply and affect interest rates? The
central bank changes the money supply primarily through Open Market Operations. These
involve the purchase and sale of government bonds in the open market.

● Expansionary policy (easy money): If the central bank buys bonds, it increases
(expands) the supply of money. This increases bond prices, which leads to a decrease
in the rate of interest. This encourages investment, potentially increasing income (GDP)
and employment (expansionary monetary policy).
● Contractionary policy (tight money): If the central bank sells bonds, it decreases
(contracts) the supply of money. This decreases bond prices, which leads to an increase
 in the rate of interest. The central bank sells bonds to reduce money supply and control
inflation.

There is an inverse relationship between bond prices and the rate of interest.

The central bank can either set the money supply and let the interest rate be determined by the
market, or set the interest rate and adjust the money supply to achieve it. Choosing to lower the
interest rate is equivalent to increasing the money supply.

In the US, the interest rate determined in the market for bank reserves is called the federal
funds rate. This is where banks with excess reserves lend to banks with insufficient reserves.
The Fed influences this rate by changing the supply of central bank money through open-market
operations with banks. Buying securities from banks increases their reserves, lowering the
federal funds rate. Selling securities to banks decreases their reserves, increasing the federal
funds rate. The federal funds rate is considered the major tool for US monetary policy.

What do banks do and how do they create money? Banks are financial intermediaries that
accept deposits and give loans. They receive funds from people and firms, creating deposit
accounts (their liabilities). Banks keep a portion of these funds as reserves.

Banks hold reserves for several reasons: to meet customer withdrawals and deposits, to handle
transactions with other banks, and due to reserve requirements set by the central bank. In the
US, the actual reserve ratio is about 10%.

The money supply is increased through a process called money creation. The central bank
controls the monetary base (High-powered Money, H), but the overall money supply (M) is
much larger. Most of the money supply (97%) is in the form of bank deposits, created by
commercial banks when they issue loans. Banks create electronic deposit money, not physical
cash. Every new loan creates new money.

This process relies on fractional reserve banking, where banks hold only a fraction of
customer deposits as reserves, assuming not all customers will withdraw at once. The deposits
not held as reserves are lent out, creating new money. Reserves are deposits banks have
received but not lent. In a 100% reserve system, banks hold all deposits as reserves and do not
create money. In fractional-reserve banking, banks do create money.

The amount of money created from an initial deposit is calculated by dividing the deposit by the
reserve requirement ratio. For example, with a 20% reserve requirement, a $100 deposit can
lead to $500 in total money created ($100 / 0.20).

What is the money multiplier? The overall money supply (M) is linked to the monetary base
(H) by the money multiplier. The simple money multiplier is given by 1 / Reserve Requirement
Ratio, assuming the public holds no currency and banks hold no excess reserves. This
multiplier is greater than 1.

A more complete money multiplier accounts for the public's demand for currency. The demand
for central bank money (Hd) is the sum of the demand for currency by the public (CUd) and the
demand for reserves by banks (Rd). If 'c' is the fixed proportion of money people hold as
currency and (1-c) in deposits, and '' is the reserve ratio banks hold against deposits, then CUd
= cMd and Rd = (1-c)Md. Thus, Hd = cMd + (1-c)Md = (c + (1-c))Md.
At equilibrium, the supply of central bank money (H) equals the demand (Hd): H = (c + (1-c))Md.
Since the overall money supply (M) equals total money demand (Md), we have M = [1 / (c + (1-
c))] * H. The term m = 1 / (c + (1-c)) is the money multiplier. Since c + (1-c) is less than 1, the
multiplier is greater than 1.

The money multiplier is larger when the reserve ratio () is smaller and when the currency-
deposit ratio (c) is smaller. A smaller 'c' means a larger proportion of the monetary base is
available for bank reserves, facilitating more loans and credit creation. Payment habits (like
ATM availability) affect 'c', and banks changing excess reserves also affect the multiplier.

What is a bank run? A bank run occurs when rumors that a bank is in trouble cause many
depositors to withdraw their funds simultaneously. If enough people do this, the bank can run
out of reserves. In the US, federal deposit insurance helps prevent bank runs. An alternative,
narrow banking, restricts banks to holding only liquid, safe government bonds, which would
prevent runs but reduce profitability and depositor interest earnings.

What is a liquidity trap? A liquidity trap is a situation characterized by a very low interest rate
where economic agents expect the rate to rise in the future. In this scenario, everyone prefers to
hold their wealth in money, and the speculative demand for money becomes infinite. In such a
situation, monetary policy is considered ineffective. However, if investors are still willing to hold
bonds even when interest rates are low, it is not classified as a liquidity trap.
Introduction to Macroeconomics and Economic Theories

The term macroeconomics originated in the 1930s. The study of forces determining income,
employment, and prices gained prominence since the turn of the twentieth century, accelerating
with the World Depression that began in 1929. A comprehensive theory to explain national
income determination and equilibrium aggregate income and output was first put forward by
John Maynard Keynes in his masterpiece ‘The General Theory of Employment Interest and
Money’ published in 1936. To understand the ideas of the Keynesian revolution, it is essential
to first understand the Classical system that Keynes critiqued.

Classical Macroeconomics

Classical economists, including figures like Adam Smith and A.C. Pigou, wrote from the 1770s
to the 1930s. The classical model was the first attempt to explain the determinants of the price
level, real GDP, employment, consumption, saving, and investment. Classical economics
emerged as a revolution against mercantilism, which emphasized bullionism (wealth in precious
metals) and state intervention.

Two key features of classical analysis are:

1. Stress on real factors: Output and employment are primarily determined by real factors
like factors of production and technology, not monetary factors. Money primarily
functions as a means of exchange.
2. Self-adjusting tendencies: The economy naturally tends towards equilibrium without
requiring government intervention. Government policies to manage demand were
considered unnecessary and often harmful.

Determination of Output and Employment (Supply Side)

In the classical model, the quantity of labour employed is determined by the forces of supply
and demand in the labour market. Output and employment levels are determined solely by
supply factors.

● Factors of Production and Labour Demand: Factors of production are inputs used to
produce goods and services. The demand for a factor of production is a derived
demand, stemming from a firm's decision to supply a good in another market. Firms are
assumed to be perfect competitors maximising profits. The aggregate production
function relates the level of output (Y) to the level of factor inputs, typically capital (K)
and labour (N), as Y = F(K, N). In the short run, the stock of capital, technology, and
population are assumed constant.
● Marginal Product of Labour (MPN): This is the increase in output (∆Q) from
adding one unit of labour (∆N). MPN = ∆Q/∆N. The classical model assumes
diminishing marginal product of labour: as more workers are hired, each additional
worker contributes less to total production than the previous one.
● Firm's Labour Demand: A profit-maximising competitive firm hires labour up to the
point where the value of the marginal product of labour (VMPN) equals the money
wage (W). VMPN is the MPN multiplied by the price of the output (P). VMPN = P x MPN
= W. Dividing by P, the condition becomes MPN = W/P, meaning the firm hires labour
until the marginal output of the last worker equals the real wage (W/P). The VMPN
 curve is the firm's labour demand curve and is downward sloping due to diminishing
marginal product.
● Labour Supply: Labour is supplied by individuals seeking to maximise utility, which
depends on both real income and leisure. There is a trade-off between income and
leisure. A change in the wage rate has two effects: the substitution effect (higher wage
increases the opportunity cost of leisure, encouraging more work) and the income
effect (higher wage increases real income, potentially leading to a desire for more
leisure). While a backward-bending supply curve is possible at very high wages (income
effect outweighs substitution effect), the aggregate labour supply curve in the classical
model is assumed to have a positive slope (substitution effect outweighs income
effect). Labour supply is determined by the real wage (W/P), not the money wage.
● Equilibrium in the Labour Market: Equilibrium employment (N0) and the equilibrium
real wage (W/P)0 are determined by the intersection of the aggregate labour demand
and supply curves. At this equilibrium employment level, the production function
determines the equilibrium level of output (Y0).
● Classical Aggregate Supply: The classical aggregate supply curve is vertical. This
signifies that output is determined solely by supply-side factors. If the price level
increases, firms initially demand more labour (as real wages fall), but this creates excess
demand for labour, causing money wages to rise proportionally. Money wages rise by
the same proportion as prices, leaving the real wage unchanged at the equilibrium level.
Since the real wage and employment remain unchanged, output also remains
unchanged, regardless of the price level.

Determination of the Interest Rate

In the classical system, the interest rate is determined in the loanable funds market. It plays a
crucial role in equilibrating saving and investment and preventing changes in aggregate demand
components from affecting overall demand and output.

● Demand for Loanable Funds: This comes from businesses borrowing to finance
investment (I) and the government borrowing to finance its deficit (G-T). Investment is
a negative function of the interest rate, as a lower rate makes more potential projects
profitable. Government borrowing (G-T) is typically assumed exogenous.
● Supply of Loanable Funds: This comes from individuals saving (S). Saving is an
increasing function of the interest rate, as a higher rate increases the return to saving
(future consumption relative to current consumption).
● Equilibrium Interest Rate: The equilibrium interest rate (r0) is where the supply of
loanable funds equals the demand for loanable funds: S = I + (G-T).
● Stabilizing Role: The interest rate adjustment is seen as the "first line of defense for full
employment". If investment demand falls autonomously, the interest rate drops. This
lower interest rate stimulates both an increase in investment (movement along the I
curve) and a decrease in saving (increase in consumption). The interest-rate-induced
increase in consumption and investment precisely offsets the initial autonomous decline
in investment, keeping total demand (C+I) unchanged.

Classical Aggregate Demand

The classical theory of aggregate demand is an implicit theory based on the Quantity Theory
of Money (QTM).
 ● QTM: In its simplest form (Cambridge equation), it's M/P = kY, where M is the money
supply, P is the price level, k is the proportion of income held as money (assumed
stable), and Y is real output. Fisher's equation is MV = PY, where V is the velocity of
money (assumed stable).
● AD Curve: For a given money supply (M) and stable velocity (V) or k, the QTM (PY =
MV) describes an inverse relationship between the price level (P) and the demanded
output (Yd). This relationship gives the downward-sloping aggregate demand curve.
● Determinants of AD: In the classical model, for a given V (or k), a change in the
quantity of money (M) is the only factor that shifts the aggregate demand curve.
● Equilibrium of AD and AS: The vertical aggregate supply curve determines the level of
output (Y). The intersection of the downward-sloping AD curve and the vertical AS curve
determines the equilibrium price level. Changes in M shift the AD curve, leading only
to changes in the price level, not output.

Policy Implications (Classical)

Classical economists generally advocated for a non-interventionist policy approach.

● Fiscal Policy (Government Spending and Taxes):

○ Increases in government spending (G) financed by selling bonds (borrowing)
increase the demand for loanable funds, driving up the interest rate. This leads to
crowding out of an equal amount of private expenditure (consumption and
investment fall as the interest rate rises). Total aggregate demand is unchanged,
and therefore output and the price level are unaffected (unless M changes).
○ Tax cuts that increase disposable income also stimulate consumption. If
financed by selling bonds, the same crowding out process occurs, leaving
aggregate demand unaffected.
○ If G increases or taxes are cut and financed by creating new money, this
increases the money supply (M). The increase in M shifts the AD curve and
causes a proportionate increase in the price level, but output remains unchanged
due to the vertical AS curve. The increase in G or tax cut itself has no
independent effect on output or employment.
● Supply-Side Effects of Taxes: Changes in marginal tax rates (e.g., income tax rate)
affect incentives to work and thus impact the labour supply. A cut in the marginal
income tax rate increases the after-tax real wage, shifting the labour supply curve to the
right, increasing equilibrium employment and output. This is a supply-side effect that
does affect output in the classical model.
● Monetary Policy (Change in Money Supply): In the classical system, monetary policy
determines the price level and nominal income, but does not affect equilibrium real
variables like output, employment, or the interest rate. Money is considered a "veil" over
the real economy. Changes in M primarily cause proportional changes in P.

Keynesian Macroeconomics

Keynesian theory focuses on the mutual interaction between output and spending: spending
determines output and income, and output and income also determine spending. The theory of
national income determination is based on Aggregate Demand (AD).

● Equilibrium Aggregate Income: The equilibrium level of income occurs when the
desired amount of output demanded by all agents exactly equals the amount
produced. In other words, aggregate demand (AD) equals aggregate supply
 (output, Y). This equilibrium does not necessarily mean full employment; equilibrium
can occur with high unemployment.
● Aggregate Demand (AD): AD, or aggregate expenditure, is the total amount of goods
and services demanded in the economy. Its components depend on the model being
used.
● Two-Sector Model (Household + Business):
○ Assumptions: Only households and firms exist. No government (no taxes,
government spending, or transfers) and a closed economy (no foreign trade). All
income accrues to households (Y = Yd, disposable income). Prices, capital
supply, and technology are constant. Investment (I) is assumed to be
autonomous (exogenously determined, constant in the short run).
○ AD components: Aggregate demand consists of aggregate demand for consumer
goods (C) and aggregate demand for investment goods (I). AD = C + I. Since I is
autonomous (Ī), the short-run AD function is AD = C + Ī.
○ Equilibrium condition: In equilibrium, Y = C + I. Equivalently, since Y = C + S
(income is either consumed or saved), the equilibrium condition is C + I = C + S,
which simplifies to I = S (planned investment equals saving).
○ Adjustment to Equilibrium: If AD > Y, firms experience unplanned inventory
decreases (IU < 0) and increase production, increasing income. If Y > AD, firms
experience unplanned inventory increases (IU > 0) and decrease production,
decreasing income. This process continues until Y = AD (or S = I), where
unplanned inventory changes are zero.
● Three-Sector Model (Household + Business + Government):
○ Includes household, business, and government sectors. Closed economy (no
foreign trade).
○ Government Role: Imposes taxes (T) on households and businesses, makes
transfer payments (TR) to households and subsidies to businesses, purchases
goods and services (G), and borrows in financial markets to finance deficits.
Taxes and saving are leakages from the circular flow, while investment and
government purchases are injections.
○ AD components: Household consumption (C), desired business investment (I),
and government sector's demand (G). AD = C + I + G. Investment (I) and
government spending (G) are assumed autonomous in the simple model.
Consumption (C) now depends on disposable income (YD = Y - T + TR).
○ Equilibrium condition: In equilibrium, Y = C + I + G. Equivalently, S + T = I + G
(total leakages equal total injections).
● Four-Sector Model (Household + Business + Government + Foreign):
○ Includes household, business, government, and foreign sectors.
○ Foreign Sector Flows: Adds exports (X), imports (M), and net capital inflow.
Exports are an injection (foreign demand for domestic output), imports are a
leakage (demand for foreign goods).
○ AD components: C + I + G + net exports (X-M). AD = C + I + G + (X-M).
○ Equilibrium condition: In equilibrium, Y = C + I + G + (X-M). Equivalently, S + T +
M = I + G + X (total leakages equal total injections).
○ Imports are assumed to depend on income (marginal propensity to import, v),
while exports depend on foreign income (exogenous). If net exports (X-M) are
positive (X>M), there is a net injection, increasing national income. If X-M are
negative (X<M), there is a net withdrawal, decreasing national income.

Consumption and Saving Functions

 ● Consumption Function: Describes the positive relationship between aggregate
consumption expenditure (C) and aggregate disposable income (Yd). The specific linear
form proposed by Keynes is C = a + bYd.
○ 'a' is a constant representing autonomous consumption – consumption at zero
disposable income.
○ 'b' is the slope of the consumption function and represents the Marginal
Propensity to Consume (MPC). MPC is the increase in consumption (∆C)
per unit increase in disposable income (∆Yd). Keynes assumed 0 < b < 1
(consumption increases with income, but by less than the income increase).
MPC is usually less than 1.
○ Average Propensity to Consume (APC): The ratio of total consumption to total
income. APC = C/Yd. APC decreases as income increases.
● Saving Function: Since income is either spent or saved, saving is also a function of
income. S = Yd - C. Substituting the consumption function, S = Yd - (a + bYd) = -a + (1-
b)Yd.
○ '-a' is the (negative) level of saving at zero disposable income.
○ (1-b) is the slope of the saving function and represents the Marginal Propensity
to Save (MPS). MPS is the increase in saving (∆S) per unit increase in
disposable income (∆Yd). MPS = ∆S/∆Yd = 1-b.
○ MPC + MPS = 1. Since 0 < b < 1, MPS must be positive (0 < (1-b) < 1).
Therefore, saving is an increasing function of the level of income.
○ Average Propensity to Save (APS): The ratio of total saving to total income.
APS = S/Yd.

The Multiplier

The multiplier is a central concept in Keynesian theory. It explains how an initial change in
autonomous spending (an injection) leads to a proportionately larger change in the
equilibrium level of national income.

● Investment Multiplier (k): Defined as the ratio of the change in national income
(∆Y) to the initial change in investment (∆I). k = ∆Y / ∆I.
● Multiplier Process: An increase in autonomous investment (∆I) directly
increases income by ∆I. Recipients of this income increase spend a portion
based on their MPC (c * ∆I), leading to a second round of income increase.
This induced consumption generates further income increases (c² * ∆I, c³ * ∆I,
and so on), creating a chain reaction.
● Value of the Multiplier: Summing the successive rounds of spending (∆A + c∆A
+ c²∆A + ...), the total change in AD (and thus Y) is given by the formula: ∆Y
= ∆A * [1 / (1 - c)].
○ In a simple two-sector model (no government, no foreign trade), the
multiplier for a change in autonomous spending (∆A, e.g., ∆I or ∆a) is k
= 1 / (1 - MPC).
○ The MPC is the determinant of the value of the multiplier. A higher MPC
leads to a larger multiplier.
● Multiplier with Government and Foreign Trade:
○ With a proportional income tax (t), the MPC out of national income becomes
c(1-t). The autonomous expenditure multiplier is 1 / [1 - c(1 - t)]. Income taxes
reduce the value of the multiplier.
○ In a four-sector model with imports depending on income (marginal propensity to
import, v), the autonomous expenditure multiplier is 1 / (1 - b + v), where b is the
 MPC out of disposable income. A higher propensity to import (v) leads to a
lower multiplier, as imports are a leakage of domestic income.
● Income Leakages: Factors that cause income to be withdrawn from the circular flow of
consumption expenditure are called leakages. The more powerful the leakages, the
smaller the value of the multiplier. Leakages include saving (not spent on
consumption), taxes, imports, undistributed profits, and payment of debts.

Fiscal Policy Effects (Keynesian)

In the Keynesian model, government spending and taxes (fiscal policy) can be used to affect the
level of equilibrium income.

● Government Purchases (G): G is a component of aggregate demand. An

increase in autonomous government spending (∆G) shifts the AD curve
upward and increases equilibrium income by the multiplier times the change
in G. The multiplier for G (in the model with proportional taxes) is 1 / [1 - c(1 -
t)].
● Transfers (TR): Transfers affect disposable income and thus consumption. An
increase in transfers (∆TR) increases autonomous consumption by c * ∆TR,
which shifts the AD curve upward. The effect on equilibrium income is the
multiplier times c * ∆TR. The multiplier for transfers is c / [1 - c(1 - t)], which is
smaller than the multiplier for G because part of the increased transfer payment is
saved.
● Taxes (TA): Taxes reduce disposable income and consumption. A proportional income
tax (TA = tY) reduces the marginal propensity to consume out of national income to c(1-
t). An increase in the tax rate (t) flattens the AD curve and reduces the value of the
multiplier.
● Automatic Stabilizers: Mechanisms that automatically reduce fluctuations in output in
response to changes in autonomous demand. They work by reducing the size of the
multiplier. Examples include proportional income taxes (which lower the multiplier) and
unemployment benefits (which cause transfers to rise and disposable
income/consumption to fall less when income falls due to unemployment).
● Government Budget Surplus (BS): Defined as total government revenues (TA) minus
total government expenditures (G + TR). BS = TA - G - TR. If TA = tY, then BS = tY - G
- TR. The budget surplus depends on government policy (G, t, TR) and the level of
income (Y). An increase in G reduces the BS (or increases the deficit). An increase in
the tax rate (t) increases the BS.
● Full-Employment Budget Surplus (BS*): A measure of the stance of fiscal policy that
is independent of the current position in the business cycle. It measures the budget
surplus that would occur if the economy were at the full-employment level of income
(Y*). BS* = tY* - G - TR. The difference between the actual budget surplus and the full-
employment budget surplus is the cyclical component of the budget.

Comparison of Classical and Keynesian Views

● Output and Employment: Classical theory holds that output and employment are
determined by supply-side factors and flexible wages/prices ensure equilibrium at full
employment. Keynesian theory argues that output and employment are determined by
aggregate demand, and equilibrium can occur below full employment if AD is insufficient,
especially due to sticky wages and prices (assumed in the simple model).
 ● Role of Aggregate Demand: In the Classical model, AD determines the price level for a
given level of output determined by supply. In the Keynesian model, AD determines the
level of output and income.
● Role of Money: Classical theory posits that money is a veil and only affects nominal
variables. Keynesian theory suggests that money can affect real variables, particularly if
prices and wages are not fully flexible.
● Role of Interest Rate: Classical theory sees the interest rate as the primary mechanism
equilibrating saving and investment, ensuring sectoral demand changes do not affect
total demand or output. The simple Keynesian model focuses on the AD components
and the multiplier, without highlighting the interest rate's primary role in equilibrating S
and I across sectors, although investment is a component of AD.
● Policy Implications: Classical economics advocates non-interventionism, believing the
economy is self-adjusting. Keynesian economics supports interventionist fiscal policy
(managing G and T) to influence aggregate demand and stabilise the economy,
particularly to address unemployment resulting from insufficient demand.

The provided sources introduce the IS-LM model, which is described as the core of short-run
macroeconomics. This model is used to study the interaction of the goods market and the
money market. It links these two markets through two key economic variables: the interest
rate (i) and income/GDP (Y). The model aims to find the values of GDP and the interest rate
that simultaneously ensure equilibrium in both the goods and money markets. A major
assumption for the initial development of this analysis is that the price level is constant, and
firms are willing to supply any amount of output demanded at that price level, corresponding to a
flat short-run aggregate supply curve.

1. The Goods Market and the IS Curve

● Previous Model: The source notes that a previous chapter looked at a simple model of
the goods market where equilibrium output equalled aggregate demand, with one market
(goods) cleared by one variable (GDP/Y).
● Introduction of Interest Rate: The IS-LM framework introduces the interest rate into
the goods market via investment demand. This leaves the goods market with one
market but two variables: GDP (Y) and the interest rate (i).
● Definition of IS Curve: The IS curve is defined as the schedule showing combinations
of interest rates and levels of output such that planned spending equals income.
In other words, it represents the goods market equilibrium schedule.
● Derivation of the IS Curve: The IS curve is derived in two main steps:
○ Establishing the link between interest rates and investment.
○ Establishing the link between investment demand and aggregate demand
(AD).
● Investment and the Interest Rate:
○ Investment is no longer treated as exogenous but depends on the interest rate,
making it an endogenous variable in this context.
○ Investment demand is inversely related to interest rates. The interest rate is
considered the cost of borrowing money. A higher interest rate increases the cost
for firms to borrow for capital equipment, leading them to reduce the quantity of
investment demand.
○ The investment spending function is specified as biII −=. Here, I
represents investment spending, I-bar ( ) is autonomous investment
 spending, i is the rate of interest, and b is the responsiveness of
investment spending to the interest rate. The negative slope reflects the
assumption that a reduction in 'i' increases the quantity of 'I'.
○ The investment schedule is determined by its slope, 'b', and the level of
autonomous spending ( ). A large 'b' (highly responsive investment to 'i') results
in an almost flat investment schedule. A small 'b' (investment responds little to 'i')
results in a close to vertical investment schedule. An increase in autonomous
spending shifts the investment schedule outwards, while a decrease shifts it
inwards.
● Interest Rate and Aggregate Demand:
○ Since investment is now a function of the interest rate, the AD function
from the previous model is modified. The new AD function is given by
biYtcA −−+= )1(.
○ An increase in 'i' reduces investment, which in turn reduces AD for a given level
of income.
○ For any given level of 'i', the equilibrium level of income can be determined as in
the simpler goods market model. A change in 'i' will change this equilibrium.
● Deriving the Curve:
○ For a given interest rate, say i1, the AD function has a specific
intercept ( 1biA − ). The equilibrium income is Y1. The pair (i1, Y1)
represents a point on the IS curve.
○ If the interest rate falls to i2 (lower than i1), the intercept of the AD
curve increases ( 2biA − , where i2 < i1). This shifts the AD curve
upward, leading to a higher equilibrium income, Y2. The pair (i2, Y2) is
another point on the IS curve.
○ Repeating this for different interest rates generates additional points on the IS
curve. This process shows the negative relationship between 'i' and 'Y' on
the IS curve.
● IS Curve Equation: The goods market equilibrium condition Y = AD can be
used to derive the IS equation. Substituting the modified AD function and
solving for Y gives: )( biAY G −=, where ))1(1( tc G −− = is the multiplier
from the previous chapter.
● The Slope of the IS Curve: The steepness of the IS curve depends on two factors:
○ How sensitive investment spending is to changes in 'i' (the parameter 'b').
○ The multiplier (G).
○ If investment is very sensitive to 'i' (large 'b'), a given change in 'i' causes a large
change in AD, leading to a large change in Y. This results in a relatively flat IS
curve.
○ If investment responds little to 'i' (small 'b'), a given change in 'i' causes a small
change in AD and Y, resulting in a relatively steep IS curve.
○ A larger multiplier means a given change in AD (caused by a change in 'i') leads
to a larger change in Y, contributing to a flatter IS curve. Conversely, a smaller
multiplier (smaller c) contributes to a steeper IS curve.
○ The source states that the smaller the sensitivity of investment spending to
the interest rate (b) AND the smaller the multiplier (given by c), the steeper
the IS curve. Equation (5) can be solved for i to see this: b AY b A b Y i
GG −= − =. For a given change in Y, the associated change in i will
be larger if 'b' is smaller and the multiplier is smaller.
 ● Shifts in the IS Curve: The IS curve is shifted by changes in autonomous spending.
Autonomous spending includes factors like autonomous consumption, autonomous
investment ( ), government purchases (G), and transfer payments (TR).
○ An increase in autonomous spending (e.g., an increase in government
purchases or transfer payments) increases aggregate demand and increases the
income level at a given interest rate. This is represented by a rightward
(outward) shift of the IS curve. The extent of the shift is proportional to the size
of the multiplier.
○ A reduction in autonomous spending (e.g., a reduction in transfer payments or
government purchases) shifts the IS curve to the left.
○ Fiscal policy actions, such as changes in G or the tax rate (t), affect the IS curve
through autonomous spending (G is part of A) and the multiplier (t is part of G).
An increase in G, for example, increases autonomous spending (A).

2. The Money Market and the LM Curve

● Introduction of Money Market: The model then introduces the money market, where
equilibrium is determined when the demand for money equals the supply of money.
● Definition of LM Curve: The LM curve shows combinations of interest rates and
levels of output such that money demand equals money supply. It represents the
equilibrium schedule in the money market.
● Derivation of the LM Curve: The LM curve is derived in two steps:
○ Explaining why money demand depends on interest rates and income.
○ Equating money demand with money supply to find the (i, Y) combinations
that maintain money market equilibrium.
● Demand for Money:
○ The demand for money is a demand for real money balances. People care
about what their money can buy rather than the nominal amount.
○ The demand for real balances depends on two main factors:
■ Real income (Y): People hold money for purchases, which depend on
income (transaction demand). The demand for money is positively
related to income.
■ Interest rate (i): The interest rate (e.g., on bonds) is the opportunity
cost of holding money. A higher interest rate means a higher cost of
holding cash, so less cash will be held at each income level
(speculative/asset demand). The demand for money is inversely related
to the interest rate.
○ The demand for money function for real balances is defined as hikYL
−=. L represents the demand for real balances, k reflects the
sensitivity of money demand to income (k = dL/dY), and h reflects the
sensitivity of money demand to the interest rate (h = dL/di).
● Supply of Money:
○ The nominal quantity of money supplied (M) is controlled by the central bank
(e.g., the Federal Reserve).
○ The real money supply is MP/ , where M and P are initially assumed fixed.
● Money Market Equilibrium: Equilibrium in the money market requires that the
demand for real balances equals the supply of real balances: hikY P M −=.
● Deriving the Curve:
○ Starting with a given income level, Y1, there is a corresponding money demand
curve (L1). Equilibrium occurs where L1 intersects the fixed real money supply
curve, resulting in interest rate i1. The pair (i1, Y1) is a point on the LM curve.
 ○ If income increases to Y2 (higher than Y1), the money demand curve shifts to the
right (to L2) because demand for real balances increases at every level of 'i'.
Since the real money supply is fixed, the interest rate must rise to i2 to maintain
equilibrium in the money market. The new equilibrium is at point E2 (i2, Y2),
which is another point on the LM curve, higher up and to the right of E1.
○ This process shows that money market equilibrium implies that an increase
in the interest rate is accompanied by an increase in the level of income.
This is why the LM curve is positively sloped.
● LM Curve Equation: The LM curve equation is obtained by solving the money
market equilibrium condition (hikY P M −= ) for i: −= P M kY h i 1.
● The Slope of the LM Curve: The steeper the LM curve, the greater the
responsiveness of money demand to income (larger k) and the lower the
responsiveness of money demand to the interest rate (smaller h). Examining
the LM equation −= P M kY h i 1 , for a given change in income (Y), the
associated change in 'i' will be larger if 'k' is larger and 'h' is smaller.
● Shifts in the LM Curve: The real money supply (MP/ ) is held constant along a given
LM curve. A change in the real money supply will shift the LM curve.
○ An increase in the supply of real money balances (e.g., an increase in the
nominal money supply M, assuming constant P) shifts the money supply curve to
the right. To restore equilibrium at any given income level, the interest rate must
decrease to induce people to hold the larger real quantity of money. This causes
the LM curve to shift down and to the right.
○ A decrease in the supply of real money balances shifts the LM curve up and to
the left.
○ The LM curve also shifts if the price level (P) changes. A higher price level
reduces the real money supply (M/P), shifting the LM curve to the left.

3. Equilibrium in Both Markets

● The IS and LM schedules summarise the conditions for equilibrium in the goods and
money markets respectively.
● Simultaneous equilibrium requires interest rates and income levels that satisfy both
conditions. This occurs at the intersection of the IS and LM curves. The intersection
point determines the equilibrium levels of income (Y0) and the interest rate (i0) for
given levels of autonomous spending, fiscal parameters, nominal money supply, and
price level.

4. Changes in Equilibrium and Policy Effects

● The equilibrium levels of income and the interest rate change when either the IS or the
LM curve shifts.
● Fiscal Policy: Fiscal policy (changes in government spending or taxation) initially
impacts the goods market.
1. An expansionary fiscal policy (e.g., increase in G or reduction in t) shifts the
IS curve to the right.
2. Starting from equilibrium, an increase in government spending shifts the IS curve
rightward (by GG if interest rates remained constant). At the initial interest rate,
this creates an excess demand for goods.
3. However, the increase in income due to higher G leads to an increase in the
transaction demand for money. With a fixed money supply, this creates an
 excess demand for real balances in the money market, causing the interest rate
to rise to maintain money market equilibrium.
4. As the interest rate rises, planned investment spending (which is negatively
related to the interest rate) declines, dampening aggregate demand.
5. The economy moves to a new equilibrium point where the shifted IS curve
intersects the LM curve. At this new equilibrium (E'), both income and the
interest rate are higher.
6. Crowding Out: The rise in the interest rate partially offsets the expansionary
effect of fiscal policy by reducing (crowding out) private spending, particularly
investment. Crowding out occurs when expansionary fiscal policy causes
interest rates to rise, thereby reducing private spending, particularly
investment. The equilibrium increase in income (Y'0) is less than it would have
been if the interest rate had remained constant (Y”).
7. The extent of crowding out depends on the slopes of the IS and LM curves.
Crowding out is greater the more the interest rate increases when government
spending rises. Income increases more, and interest rates increase less, the
flatter the LM curve. Income increases less, and interest rates increase less, the
flatter the IS curve.
● Monetary Policy: Monetary policy (controlled by the Central Bank, primarily through
open market operations like buying/selling government bonds) initially impacts the
assets/money markets.
1. Expansionary monetary policy involves the Central Bank buying bonds,
which increases the stock of money. This increases the real money supply
(M/P), assuming constant prices.
2. An increase in the real money supply shifts the LM curve to the right.
3. At the initial equilibrium, the increase in money supply creates an excess supply
of money. The public tries to reduce money holdings by buying other assets
(bonds), which drives up asset prices and lowers yields (interest rates). This
moves the economy to a point where the money market clears at a lower interest
rate.
4. At this lower interest rate, there is now an excess demand for goods because
lower interest rates stimulate investment (part of AD). Increased AD causes
inventories to fall, leading firms to expand output.
5. As output increases, the demand for money (transaction demand) rises, leading
to bond sales and upward pressure on interest rates.
6. The economy moves along the new LM curve until it intersects the IS curve. The
new equilibrium (E') is at a lower interest rate and a higher level of income.
7. Contractionary monetary policy (Central Bank selling bonds, reducing money
supply) shifts the LM curve to the left, leading to lower income and higher
interest rates.
8. The effectiveness of monetary policy depends on the steepness of the LM curve.
If the demand for money is very sensitive to the interest rate (flat LM, large h), a
given change in money supply causes only a small change in interest rates, thus
having a small effect on investment and output. If the demand for money is not
very sensitive to the interest rate (steep LM, small h), a given change in money
supply requires a large change in interest rates to restore equilibrium, leading to
a larger effect on investment and output. If the demand for money is very
sensitive to income (large k), the monetary multiplier will be smaller.
● Transmission Mechanism: The process by which monetary policy affects aggregate
demand involves two steps:
 1. A change in real balances causes a portfolio disequilibrium, leading people to
adjust their asset holdings, which changes asset prices and interest rates.
2. The change in interest rates affects aggregate demand (primarily through
investment).

5. Extreme Cases

The sources discuss two extreme cases for the IS-LM model, particularly relevant for
understanding policy effectiveness:

● The Liquidity Trap:

○ This is a situation where the LM curve is horizontal. It occurs when the public is
willing to hold whatever amount of money is supplied at a given interest rate,
implying they don't want to buy bonds at all (infinite sensitivity of money demand
to interest rate, h approaches infinity).
○ In a liquidity trap, changes in the quantity of money do not shift the LM curve
and have no impact on either the interest rate or the level of income.
Monetary policy is powerless. The sources note this notion grew out of
Keynes's theories and that it has rarely been observed in reality but is useful for
understanding relatively flat LM curves. Low or zero interest rates might indicate
a liquidity trap situation. In such conditions, banks might be reluctant to lend
despite low rates, potentially breaking the transmission mechanism.
○ In a liquidity trap, an increase in government spending has its full multiplier
effect on income because the interest rate does not change, meaning no
investment spending is cut off. There is no crowding out.
● The Classical Case:
○ This is the opposite extreme, where the LM curve is vertical. This occurs when
the demand for money is completely unresponsive to the interest rate (h =
0).
○ When h = 0, the LM equation hikY P M −= becomes Y P M k =. This
implies that there is a unique level of income corresponding to a given
real money supply, determined solely by the quantity of money. This is
associated with the quantity theory of money, where nominal GDP (PY) is
proportional to the money supply (M).
○ In the classical case, a given change in the quantity of money has a maximal
effect on the level of income. Monetary policy is highly effective.
○ Shifts in the IS curve do not affect the level of income. A fiscal expansion (IS
shift right) only increases the interest rate. With income fixed, the increase in
government spending must be offset by an equal reduction in private spending
(particularly investment) due to the higher interest rate. There is full crowding
out. This view is sometimes associated with the idea that "only money matters"
for determining output.

6. Aggregate Demand Derivation

● The aggregate demand (AD) schedule is derived from the IS-LM equilibrium by
allowing the price level (P) to vary, holding autonomous spending and the nominal
money supply constant.
● A higher price level (P) means a lower real money supply (M/P). A lower real money
supply shifts the LM curve to the left. This leads to a higher interest rate and a lower
equilibrium level of income/output.
 ● Thus, a higher price level corresponds to a lower level of aggregate
demand/output. Plotting these pairs of P and Y generates the downward-sloping AD
curve.
● The equation for the AD curve is derived by substituting the LM equation into the IS
equation and solving for Y. The result is a complex expression, but it shows that the
equilibrium level of income (Y) depends on two exogenous variables: autonomous
spending (A and fiscal parameters) and the real money stock (M/P). Specifically, it is
higher when autonomous spending is higher and when the stock of real balances is
higher. Since P is in the denominator of M/P, the equation confirms the AD curve is
downward sloping.

7. Policy Multipliers

The sources present multipliers based on the AD equation (Equation 8), showing the impact of
changes in autonomous spending and real money supply on equilibrium income:

● Fiscal Policy Multiplier: The multiplier for a change in government spending (G) on
income (Y) is given by = + hkb h G G . Since k, b, and h are typically positive, is less
than the simple goods market multiplier G. This reduction reflects the dampening effect
of rising interest rates and crowding out within the IS-LM framework. If h approaches
zero (vertical LM, Classical Case), approaches zero. If h approaches infinity (horizontal
LM, Liquidity Trap), approaches G.
● Monetary Policy Multiplier: The multiplier showing how much an increase in the real
money supply ((M/P)) increases equilibrium income (Y) is given by h b G =. This
multiplier is larger the larger 'b' (more interest-sensitive investment) and the smaller 'h'
and 'k' (less sensitive money demand to interest rates and income, respectively).

8. The Composition of Output and the Policy Mix

● Both monetary and fiscal policies affect the level of aggregate demand and cause output
to expand. However, they differ significantly in their impact on different sectors of
the economy, affecting the composition of aggregate demand/output.
● Monetary policy operates by stimulating interest-responsive components of
aggregate demand, primarily investment spending. It is noted that the earliest effect
is often seen in residential construction. Expansionary monetary policy leads to higher
output with lower interest rates, favouring investment.
● Fiscal policy operates through government purchases (G) and changes in taxes (t)
or transfers (TR). Its impact on composition depends on the specific policy.
○ An increase in government spending raises consumption along with government
purchases.
○ An income tax cut directly affects and increases consumption spending.
○ Expansionary fiscal policies (like increased G or tax cuts) typically raise the
interest rate if the money supply is unchanged. This tends to reduce
investment due to crowding out. Thus, fiscal expansion tends to raise
consumption but reduce investment.
○ An investment subsidy is a fiscal policy that specifically aims to raise
investment by making it cheaper for firms. It shifts the investment schedule
outwards and the IS curve to the right. While the interest rate still rises in the new
equilibrium, the subsidy means that investment can end up being higher than
initially, even with the higher rate. In this case, both consumption (induced by
higher income) and investment can rise.
● Monetary Accommodation: The Central Bank can accommodate a fiscal expansion
by increasing the money supply. This involves increasing the money supply to prevent
interest rates from increasing during a fiscal expansion. This is also called "monetizing
budget deficits". When the Fed accommodates, both the IS and LM curves shift to the
right. Output increases, and interest rates need not rise, potentially avoiding the adverse
effects on investment (crowding out).
● The Policy Mix: Policymakers face a choice in reaching a target output level (e.g., full
employment) using different combinations of monetary and fiscal policy. The choice of
policy mix (e.g., relying more on fiscal vs. monetary expansion) results in different
equilibrium interest rates and, consequently, different compositions of output (e.g., more
investment vs. more consumption vs. a larger government sector). The decision on the
policy mix can be influenced by political beliefs about which sectors should benefit or the
preferred size of government.