6/21/2014 Macro +3.

2g
http://members.shaw.ca/h-chartrand/Macro%20+%203.3a.htm 1/3
3.3.1 Quick Review
a) Classical
The starting point is the equation of exchange. At any given time there are a certain number (or
volume) of transactions (i.e. T = the number of buy/sells) in the economy. The rate at which the same bills
turnover, that is the number of transactions financed with the same bills, is called the velocity of money
(V). There is also a price index (P) for the huge range of goods and services bought and sold. This is
summed up in the equation of exchange (EE) as:
Eq. 4.1 MV P
T
T or,
- the quantity of money times its velocity is identicalto the price (level) times the volume of transactions.
This presentation of EE (Eq. 4.1) is an identity in that V is derived as a residual, i.e.,
Eq. 4.2 V
T

In this version, however, transactions include not only newly produced goods and services but also
second-hand ones. For only new goods and services corresponding to factor income the EE is:
Eq 4.3 MV PY where Y is current output and P is the price index.
Again EE is an identity if V is calculated as a residual, i.e.,
Eq. 4.4 V

In the Classical (and Keynesian) Model, V is determined exogenously by payment habits and
payment technology. If so then EE ceases to be an identity. With Y fixed in the short run by supply-
factors and V fixed by institutional factors, EE becomes:
Eq. 4.5 or
Eq. 4.6
An alternative interpretation was offered by the Cambridge School known as the Cambridge
approach or the Cambridge cash-balance approach. This approach stressed that people held money (cash
balance) for convenience, compared to other stores of value, in conducting transactions. However holding
cash means that no interest will be earned from investing in productive activities. Accordingly, how much
cash would people hold? In essence the demand for money was a function of their income, i.e.,
Eq. 4.7 M
d
= kPY where
- M
d
= the demand for money;
- k = a proportion of nominal income;
- P = the price level; and,
- Y = real income.
Given, according to the Cambridge approach, that cash was desired due to its usefulness in
transactions and that the volume of transactions was a function of income then the demand for money
varies according to level of income.
In equilibrium, the supply of money (exogenously determined by monetary authorities) would equal
the demand for money, or,
6/21/2014 Macro +3.2g
http://members.shaw.ca/h-chartrand/Macro%20+%203.3a.htm 2/3
Eq. 4.8 M = M
d
= kPY where,
- k is assumed fixed in the short run; and,
- Y is determined, as before, by supply factors.
The Fisher version (Eq 4.5) and theCambridge approach (Eq. 4.7) become roughly the same if V =
1/k. Thus if people hold 1/4th of their nominal income as cash then the number of times the average dollar
is used equals four.
The big change with the Cambridge approach is the formal introduction of the demand for money.
It also allows an assessment of the impact of the quantity of money on the price level (Fig. 4.1). If the
quantity of money increases but output is fixed then people will use the extra cash to consume or invest.
Increased demand for goods raises their prices: too much money chasing too few goods. If Y is fixed as
assumed in the Classical model and k is constant then a new equilibrium will be established at which the
increase in money leads to a proportionate increase in price same output, higher prices, i.e. inflation.

b) Keynesian
Total demand for money in the Keynesian Model or MD = TD + PD + SD where TD and PD
vary positively with income and negatively with respect to interest rate while SD does not vary with
income but negatively with respect to interest rates. Taken together we can say:
(6.3) Md = L(Y, r)
and if we assume the function is linear then
(6.4) Md = co + c1Y c2r where c1 >0, c2 >0 where:
c0 is the minimum amount of cash that must be held;
c1 is the increase in money demanded per unit increase in income; and,
c2 is the decrease in money demanded per unit increase in the interest rate.
Firms borrow money from households to finance investment projects by issuing bonds (a proxy for
all interest generating assets). The price they pay for this money is the interest rate. As previously noted
Keynes assumed firms had an investment schedule that measured the expected profit rate to be earned
from alternative projects mapped against the rate of interest. If the expected profit less the cost of money
was positive, a firm ceterus paribus will undertake the project; if negative, then the project would not be
undertaken. This is called the 'real rate of return'.
If the interest rate rises, then business borrowing declines; if interest falls, borrowing increases
(Fig. 6.1). If investment increases then aggregate expenditure shifts up by the autonomous increase in I.
This increase through the aggregate expenditure multiplier will lead to an even larger increase in income.
Accordingly, the interest sensitivity of aggregate demand is important in determining appropriate monetary
polices.
In effect the interest rate is determined in two distinct markets. The first is the market for
bonds. The second is the market for money itself. Therefore one hold ones wealth (Wh = assets) as
either money or bonds (interest generating assets), i.e.,

(6.1) Wh = M + B
This means that there are two distinct money markets: one for money itself and the other for
investment financing. In the Keynesian Model overall equilibrium is established by the interaction of these
two money markets.

i LM Curve
6/21/2014 Macro +3.2g
http://members.shaw.ca/h-chartrand/Macro%20+%203.3a.htm 3/3
The first is defined by the LM curve (demand for liquidity). Fig. 6.6 demonstrates equilibrium in
the money market given Ms0 and different levels of Y(0, 1, 2). At Y0 equilibrium is achieved at r0. If Y
increases to Y1 then transactional demand increases but with a fixed money supply this increased demand
raises the price of money, i.e., the interest rate increases from r0 to r1. This increase in interest reduces
speculative demand for money and also lowers the transactional demand at any given level of Y
(opportunity cost increases leading to improved cash management practices reducing transactional
demand). Equilibrium is re-established when the increased transaction demand resulting from an increase
in Y is exactly offset by the decline in speculative and transactional demand caused by the increase in
interest rates. By varying Y we can deduce a series of points (A, B, C) where, given a fixed money
supply and increases in Y, a new equilibrium interest rate will exist (ro, r1, r2). These points (Y, r) can then
be plotted to generate the LM curve (Fig. 6.6b) that trace equilibrium conditions in the money market.

ii IS Curve
Assuming, for the moment, that there is no government sector we can simplify the equilibrium
condition as:
(6.9) I(r) = S(Y)
that is, investment as a function of the interest rate (negatively sloped) equals savings (positively sloped) as
a function of income (Fig. 6.12). At a given level of r, there is a corresponding level of investment and for
that level of investment there is a corresponding level of savings associated with a specific level of Y.
Taking r from Fig 6.12(a) and Y from 6.12(b) we can plot the IS curve showing levels of r and Y at which
I(r) = S(Y) as in Fig. 6.12 (c).

iii Equilibrium
Having created the LM curve measuring the liquidity preference equilibrium given changing r and
Y; and the IS curve measuring the savings/investment preference given changing r and Y we can now
determine simultaneous equilibrium in the money and product markers (Fig. 6.17). That it is an equilibrium
towards which it will gravitate (assuming autonomous or exogenous factors are constant) is demonstrated
in Fig. 6.18.