The expected profit­ability of new investment (or the marginal efficiency of capital, as Keynes calls it) does not determine interest but is determined by it. Keynesian theory of interest asserts that the rate of interest is determined by from ECON 101 at Catholic University of Eastern Africa That means the supply curve is flat (sticky price). Macroeconomics -Intro The two major branches of economic theory are the microeconomic theory and macroeconomic theory. He concludes that the only one that does is interest rates. II The Keynesian Theory of the Interest Rate To develop the Keynesian interest from ECON 1110 at University of Pittsburgh According to Keynes, therefore, the rate of interest depends on the liquidity preference and the supply of money. The Keynesian theory only explains interest in the short-run. Although the term has been used (and abused) to describe many things over the years, six principal tenets seem central to Keynesianism. Keynesian analysis Keynes considers seven different effects of lower wages (including the marginal efficiency of capital and interest rates) and whether or not they have an impact on employment. (The bond market is not considered explicitly in Keynes; it is eliminated implicitly by using Walras’ Law.). Keynesian Theory (IS-LM Model): how GDP and interest rates are determined in Short Run with Sticky Prices. Its main tools are government spending on infrastructure, unemployment benefits, and education. Keynes defines the rate of interest as the reward for parting with liquidity for a specified period of time. Looked at either way, monetary policy does not have much effectiveness in lowering r, especially during depression. A strong contender of Keynes’ liquidity preference theory of the rate of interest is the neoclassical loanable funds theory of rate interest. Now we can easily work out the consequences of autonomous changes in the supply of money or the demand for it. The rate of interest is determined at the point where the demand for capital is equal to the supply of capital. We have already studied Keynes’ theory of the demand for money or, which is the same thing, his theory of the liquidity preference of the public. Productivity Theory of Interest: Turgot and other physiocrats were of the opinion that interest is the … HE THEORY OF INTEREST RATE The Keynesian theory of interest rate refers to the market interest rate, i.e. Output employment and income are interchangeable terms. The other three vertical lines represent alternative supplies of money at Mo. Two things are important: one is the interest elasticity of the demand for money; the other is the initial position of economy. We begin with two economic theories about the determinants of the level of interest rates and then discuss the role of the U.S. Federal Reserve System in influencing interest rates. He also said that money is the most liquid asset and the more quickly an asset can be … This feature of the LP schedule has been called the ‘liquidity trap. If people feel that the current rate of interest is low and it is expected to rise in future, then they will borrow money at a lower rate of interest and keep cash in hand with a view to lend it in future at a higher rate of interest. Keynesian theory of income determination 1. The Quantity Theory of Money (Theory of Exchange) looks at money largely from the supply side while Keynesian approach is from the demand perspective (the desire for people to hold their wealth in cash balances instead of interest – earning assets such as treasury bills and bonds) Early quantity theorists maintained that he quantity of money (M) is exogenously determined (eg. In a later section discussing Hicks’ IS-LM model we shall see how they can be jointly determined. Keynes’ solution procedure, on the other hand, suffers from circularity of reasoning, because to determine r it assumes a given Y and to determine Y it assumes a given r and so a given I. Empirically, this elasticity has been found to be either quite low or statistically insignificant. (ii) In the Keynesian theory. Which invest­ments will be profitable depends on the rate of interest. The reverse will happen if a chance disturbance pushes the rate of interest above ro. Interest Rates Have No Effect On The Demand For Money. This theory is, therefore, characterized as the monetary theory of interest, as distinct from the real theory of the classicals. Keynesian Liquidity Preference Theory. According to Keynes General Theory, the short-term interest rate is determined by the supply and demand for money. Keynesian Economics is an economic theory of total spending in the economy and its effects on output and inflation developed by John Maynard Keynes. The upward shift in the downward-sloping demand curve for loans arises because borrowers would also be willing to pay higher r than before since they expect to recoup it from expected inflation. Image Guidelines 5. Graphical illustration of the Keynesian theory. The flexibility of the interest rate as well as other prices is the self‐adjusting mechanism of the classical theory that ensures that real GDP is always at its natural level. Changes in the quantity of money do not affect the interest rate but only influence the price level (as per the quantity theory of money). But how important, this influence is or what is the value of the interest elasticity of the demand for money (infinite, high, or very low) is an empirical matter. Rate of interest is determined by the intersection of L and M curves. This made, the distinction between nominal values and real values totally irrelevant for monetary analysis — an anti-QTM stance, because in the QTM changes in prices and through them changes in the real value of a given quantity of money play the most important role. In classical theory, the interest rate i is determined by saving and investment alone: () = (). We simply recall his equation of the demand for money: Like other economists, Keynes also assumed the supply of money to be exogenously given by the monetary authority, so that. HE THEORY OF INTEREST RATE The Keynesian theory of interest rate refers to the market interest rate, i.e. •Money rate of interest determined by saving (consumption function) and by relative demands for liquidity (money) and yield (bonds) Investment •Investment determined by (unstable) expectations and rate of interest (on borrowed money) •Marginal Efficiency of Capital (MEC) = Businessmen compare cost of financing (interest rate) with expected return (yield) •Intended saving not equal to i Therefore, the price of bonds will fall and the rate of interest goes up. The first three describe how the economy works. we can also call this theory as Liquidity Preference theory. The interest rate, Keynes says, is determined by people‘s money demand, or “liquidity preference.” It is a measure of the willingness of individuals to part with their liquid assets. The implications of Keynes’ theory for the effectiveness of monetary policy are briefly noted. LIBOR, Federal Funds Rate) through monetary policy. The demand for capital arises from investment and the supply of capital springs from savings. Plagiarism Prevention 4. Presumably it was this incapacity of monetary policy to lower long-term r significantly that had made Keynes lose faith in monetary policy for fighting depression. The theory of liquidity preference and practical policy to set the rate of interest across the spectrum are central to the discussion. Historical background: The Keynesian Theory was proposed to show what could be done to shorten the Great Depression. According to Keynes, the market interest rate depends on the demand and supply of money. It depends upon the level of income and has nothing to do with the rate of interest. Liquidity preference theory is a model that suggests that an investor should demand a higher interest rate or premium on securities with long-term … Implicitly assuming Y and so L1(Y) to be already known, he argued that the above equation would give the equilibrium value of r, of the rate of interest. Copyright 10. To sum up Keynes’ theory of interest: given the liquidity preference, the rate of interest falls as the supply of money increases and rises as the supply of money decreases, given the supply of money, the rate of interest rises as the liquidity preference increases and falls as the liquidity preference decreases and the rate of interest cannot be reduced beyond the lower limit set by the liquidity trap. Privacy Policy 8. People desire to have money in order to take advantages from knowing better than others about the future changes in the rate of interest . According to Keynes, the market interest rate depends on the demand and supply of money. So, according to this theory the rate of interest depends upon demand and supply of loanable funds. The upward shift in the upward-sloping supply curve of loans shows that lenders are willing to lend any real amount at only a higher r than before so that they can get compensated for the real loss they expect to suffer due to inflation. This phenomenon has very damaging consequences for Keynes’ theory of r, which says that monetary expansion can be used to lower r. But this will be true, at most, in a short run and for only moderate increases in the supply of money—more correctly, for increases in the supply of money which a growing economy can absorb at stable prices. The Keynesian theory takes a completely opposite view: according to Keynes, interest is primarily a monetary phenomenon. Before this, let us study Keynes’ theory diagrammatically. Now it is widely believed that both the real sector forces and money market forces determine r and real income, and the commonly-accepted model for their joint determination is Hicks’ IS-LM model. Keynes theory of interest, like the classical and loanable funds theories, is indeterminate. It means that at this extremely low rate of interest, people have no desire to lend money and will keep the whole money with them. It is the 2. This happens because, according to the liquidity-trap hypothesis, the public is willing to hold all the extra quantities of money at the same r. This is an extreme situation, which as yet has not been empirically identified in any country. As the rate of interest uses, the liquidity preference decreases and as the rate of interest falls, the liquidity preference increases. Content Filtrations 6. Thus, the interest-elasticity of the demand for money (neglected in the QTM) becomes the Key issues in the Keynesian monetary theory. To understand Keynes’ theory, we go to his analysis of the money market. Determination of the Rate of Interest: The IS and LM curves relate to income levels and interest rates. This is in sharp contrast to the classical theory in which the rate of interest is made a real phenomenon, which is determined in the commodity market by savings and investment at a level which equates the two. John Maynard Keynes is often referred to as the father of macroeconomics. The General Theory was a beginning of a new school of thought in macroeconomics which was referred to in later period as Keynesian Revolution in macroeconomic analysis. The stronger the liquidity preference, the higher the rate of interest and the weaker the liquidity preference the lower the rate of interest. Money, he argued, was much more responsive to periods of excessive saving, and would allow faster changes in the interest rate. Thus, to conclude, given the level of income, the liquidity preference and the current rate of interest are inversely related. His pioneering work "The General Theory of Employment, Interest and Money" published in 1936, provided a completely new approach to the modern study of macroeconomics.It served as a guide for both macroeconomic theory and macroeconomic policy making during the Great Depression and the period later. The flexibility of the interest rate keeps the money market , or the market for loanable funds , in equilibrium all the time and thus prevents real GDP from falling below its natural level. The question is : Why do people want to keep cash ? Keynesian economics is a theory that says the government should increase demand to boost growth. The interest rate, Keynes says, is determined by people‘s money demand, or “liquidity preference.” It is a measure of the willingness of individuals to part with their liquid assets. Only if the value of Y is already known, or known independently of r, can L1(Y) be treated as a known quantity as Keynes does, and equation L1(Y)L2(r) = M, (13.2) reduced to one equation in one unknown r. But this is not so in Keynes’ model, where r affects the rate of investment (I) which in turn affects the equilibrium level of Y. Analytically, therefore, each of the two theories is a special case of a more general theory in which both r and Y are allowed to influence Md as well as adjust to clear the money market. Keynesian theory of Income determination 2. But, according to Hansen, rate of interest is a determinate, and not a determinant. Demand for money for speculative motive is directly related with the rate of interest and bond prices. There is a serious analytical flaw in this model which we shall discuss later. Through L1 (Y) Keynes admits the influence of Y, a commodity-market variable, on the demand for money. The first one is Transaction motive which implies that  People want to keep cash for their day-to-day purchases. Useful notes on Keynes’ Monetary Theory – Explained. M1, M2, all of which are assumed to be given autonomously. According to the loanable-funds theory, the rate of interest is determined by the demand for and the supply of funds in the economy at that level at which the two (demand and supply) are equated. This would imply that to attain a given reduction in r very large increase in the supply of money will be required or, which is the same thing, for a given increase in the quantity of money the reduction in r will be very small. Hence Keynes concluded that r was a purely monetary phenomenon. C) interest rates … The said interest-elasticity varies from one point on the Md curve to the other; it is assumed to be indefinite at some very low value of r (r in Figure 13.1), which defines Keynes’ liquidity trap. A less extreme situation obtains to the left of the liquidity trap. How much amount will be kept in cash for transaction and precautionary motives ? That is, for the money market to be in equilibrium, the value of r has to be such at which the public is willing to hold all the amount of money supplied by the monetary authority. According to the ‘liquidity-trap’ hypothesis, there is some r low enough at which the public is willing to hold any amount of money instead of bonds. To sum up Keynes’ theory of interest: given the liquidity preference, the rate of interest falls as the supply of money increases and rises as the supply of money decreases, given the supply of money, the rate of interest rises as the liquidity preference increases and falls as the liquidity preference decreases and the rate of interest cannot be reduced beyond the lower limit set by the liquidity trap. 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