The traditional version of the monetary transmission mechanism is associated with the IS-LM model. The change in the money supply influences the equilibrium interest rate, which estimates the costs of attracting capital resources, which affects the investment decisions of firms and households. This option is implemented through several channels.
The transmission mechanism in the version of J. M. Keynes works through the financial sector. In order to identify the essence of the matter and not get confused in the inadequate details at this stage, let's take two assumptions. Firstly, we will assume that the supply of money is wholly determined by the supply of a monetary base from the Central Bank. Secondly, let the demand for money - this is the demand for cash on the part of households and the demand for reserves from commercial banks.
In this simple model, the central bank is the dominant money market agent. We consider initially only that part of the financial sector, which is represented by the cash and current deposits of commercial banks. Such a supply of money does not depend on the interest rate. Therefore, the function of the money supply is absolutely inelastic with respect to the interest rate. The money supply line looks like a vertical straight line (Figure 9.1, a).
Fig. 9.1. Equilibrium in the money market and the line LM
The demand function for money depends on the interest rate, because part of the money demand is represented by speculative demand for money as an asset. The demand function for money is characterized by a negative slope. In addition, the demand for money positively depends on the income of individuals: the greater the income (output in the economy), the higher the transaction demand.
In Fig. 9.1, a represents the equilibrium in the money market. Let the initial situation be described by such a ratio of output (income) in the economy, demand for money and money supply, as at point 1. The interest rate i 1 when issuing Y 1 balances the interests of the holders of money and the central bank. We indicate this point on the graph in the coordinates ( i , Y ) (Figure 9.1, b).
Suppose now that the incomes of all economic agents have grown (output increased from Y 1 to Y 2) . The demand of individuals and firms for money as a medium of circulation will also increase, as with higher incomes, costs will be higher, and more monetary units are required to service increased circulation. The demand function will move up. A higher demand for money with a constant supply of money will mean an increase in the price of money-the interest rate. A new equilibrium in the money market will be reached at point 2. Fig. 9.1 , b point 2 corresponds to a new ratio of the interest rate and the real issue, which balances the money market ( i 2; Y 2).
So, with each level of income, you can find an adequate level of money demand and the equilibrium interest rate. By connecting all such points in a single line, we get the function LM (liquidity = money), which shows all the bet combinations percent and GDP level in the economy, under which the demand for money equals the supply of money.
The points above LM characterize the excessive supply of money. The points below LM are characterized by excessive demand for money.
Let's derive the equation LM. Let the real demand for money depend on two key factors, real output (real income) and nominal interest rate:
Since we do not know the exact dependence of money demand on the interest rate, we can leave this part as a function, assuming that, most likely, this dependence is not linear. However, in order to obtain a quantitative expression for the line LM, , it is advisable to use a simplified version with a linear function of the demand for money:
Equilibrium in the money market is achieved where the real demand for money is equal to the real money offer:
We substitute the corresponding functions:
How do we express the interest rate through the issue:
We finally get the equation for the line LM:
The line LM is characterized by a positive slope: with a higher yield, only a higher nominal interest rate is able to balance the supply of money and the demand for money.
The LM line can also be steep and sloping (Figure 9.2).
Fig. 9.2. A flat and steep line LM: and - a sloping LM; b - cool LM
The degree of steepness and flatness of the line LM depends on three factors: the elasticity of demand for money on income, the percentage elasticity of demand for money, and the speed of circulation of money. The ratio of the values of these factors and the degree of steepness of the line LM are presented in Table. 9.2.
When the parameters presented in Table 1 change. 9.2, the line LM changes its slope, turning along the horizontal axis outward or inward.
For example, when the elasticity of demand for money increases with respect to income, the line LM turns left - inward, its slope increases (Figure 9.3). This is due to the fact that with higher elasticity, economic agents dramatically increase their cash reserves in response to even a small increase in income, which requires a significant increase in the interest rate for keeping the money market in balance.
Elasticity of demand for money in relation to income
Speed of money
Elasticity of demand for money relative to the interest rate
Fig. 9.3. Line rotation LM
When there is a change in the money supply, or a change in the price level, the line LM moves parallel up or parallel down. For example, an increase in the nominal supply of money reduces the value of a monetary unit-the interest rate for each level of income. Therefore, the line LM shifts to the right downwards (Figure 9.4, a). The rise in the price level leads to a rise in the cost of all goods and services, including money. Now a higher nominal interest rate is needed to balance the money market at each level of income - and the line LM shifts to the left-up (Figure 9.4, b)
Question for reflection
How do you think the line LM for the United States economy looks like? What do you think, during the 2000s. this line (1) has not changed; (2) became more steep; (3) has become more flat?
The IS-LM model allows you to evaluate the effects of various economic events and the effectiveness of public policy.
For example, let the central bank of the country conduct a stimulating monetary policy, increasing the nominal money supply. What will be the consequences for the economy?
Fig. 9.4. Line Shifts LM
The increase in nominal money supply in the country leads to a drop in the price of money at each output level, which is expressed in the parallel shift of the line LM to the right - downwards (Figure 9.5). In the hands of people, now there is a large amount of monetary units. Households are starting to spend more. Firms are expanding production, adapting to the growing demand for goods and services. The aggregate demand in the economy is growing, which is reflected in the movement along the line IS to the right. Although nothing happened directly in the real sector - and therefore the line IS remains in its place, additional money supply has an impact on the real behavior of economic agents at least in the short term, which is in the model IS-LM.
Fig. 9.5. Incentive Monetary Policy in the Model IS-LM
The final result is: a lower equilibrium interest rate and a higher level of aggregate output. Lowering the interest rate is due to the presence of excess money, which put pressure on the financial system. The growth of output is associated with the expansion of aggregate demand and the effect of additional costs, flowing from the financial sector to the real.
Thus, according to JM Keynes, the change in the money supply affects the interest rate, and the dynamics of the interest rate causes changes in total costs (mainly in investment expenditures). Since there are only two relevant assets in the portfolio of investments of economic agents - money and bonds, the transmission mechanism turns out to be quite simple: an individual or firm is chosen between the amount of money or the number of bonds. The efficiency of the transmission mechanism depends on the percentage elasticity of the demand for money and on the percentage elasticity of aggregate demand (investment spending). The sloping line IS and the steep line LM provide the greatest momentum to the monetary momentum.
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