CHAPTER 6

1. CHAPTER 6 MONEY, INTEREST & INCOME (STILL UNDER KEYNES FRAMEWORK)

2. Common Rule • Ms r I AD Y ; S. What is this? • - Keynesian approach in explaining Money, Interest rate Income- inter related to AD. • Do you want to deposit money in bank if r drop?

3. MONEY, INTEREST & INCOME • 2 relation ship • 1- interest rate and AD • 2- interest rate and Money

4. Interest Rate and AD • Eg: Housing construction a) Developer side do a short term loan if r = cost b) Buyer side do a long term loan if r ; mortgage interest cost of buying house then DD new house slowdown new project DD durable goods like car, computer bcoz all this need loans

5. Interest Rate and AD • Refer to Fig 6-1 in text book • r AD (why) Eo – E1 Yo – Y1 • How big the output depend on size of AD shift caused by r • More sensitive AD component to r change the larger will be the shift • * negative relation r and I *

6. Interest Rate and Money • Assumptions; 2 groups of financial assets a) money - SR money, currency and bank acct (M1) - all money pays no r b) nonmoney assets - LR money, eg: bond, stock, equities - interest-earning assets (dpt return ler tu) - homogeneous; RM1 now = RM 1 future

7. Interest Rate and Money • Individual(s) work and get income or wealth • How they can keep this wealth Wh = B + M where Wh = wealth B = Bond M = Money • What does it means if the equation as below • Wh = 10,000 + 40,000 • Individu would prefer to hold money rather than bond • or we can say as the DD for money is bigger than DD for bond

8. r equilibrium • Assumption; • the money supply is fixed or exogenous (why) • Ms determined by central bank and by the market equilibrium which end up with vertical line. r Ms ro Md • M • ro : r equilibrium • (supply and demand so r is price for money, actually)

9. Theory of Money Demand (Md) • Because Ms is exogen so keynes put more focus on Md • (We should answer this question; why we want money @ wealth?) 1) Transaction - medium of exchange; buy goods, pay for services etc. 2) Precautionary - life is uncertain so we need to prepare for any contigencies - dah makan smp terkentut2, sakit plak. So how to ready with this scenario?

10. Theory of Money Demand (Md) 3) Speculative - people try to get profit from money in hand - since holding money have no return, it is good to buy bond and get profit. - if purchase bond at high market r then if the market r drop people will make a profit because the value of the bond would increased.

11. The equation for Md is • Mi = Mi1 + Mi2 • Where Mi1 = Md for transaction & precautionary • Mi2 = Md for speculative • And • Whi = Mi + Bi

12. Theory of Money Demand (Md) • Explain fig 6-4 • Def rn : ind always believe up to certain point the r will drops : bond will be preferred Mds=0 rc : critical r : expected capital loss to bond = interest earning on bond : r below rc bond will be sell and ind hold as a money (Mds) • r > rc : Mds = 0 • r < rc : Mds = +ve • Liquidity trap: at a very low of r the Mds becomes nearly horizontal

13. The Total Demand for Money • Md = L(Y,r) +ve to income -ve to r income M1 r M2 • Md = co + c1Y – c2r c1>0, c2>0 • (What is c1 and c2?) • From this equation we can make Md function as a straight line in a graph.

14. Explain fig 6.5 • Excess supply of money • Now you know why ms r Md (Yo)

15. THE IS - LM • What is IS? • What is LM?