Question

1. Explain carefully the Keynesian theory of money demand. Then discuss the critiques made by Friedman to the Keynesian theory of money demand.

2. Derive carefully the IS curve and discuss the determinants of its slope and its position.

Answer 1

Keynes emphasised on liquidity preference of money . According to Keynesian theory of money ,people demand money for  three reasons :

Transaction motive : Individuals receive income periodically but cannot spend all of it at once , so this leads to demand for money which is known as transaction demand for money ie used for daily needs.

Precautionary motive : When money is held for certain emergencies . This type of money is inelastic to interest rate as the indiviudal prefers to keep such money for uncertain future.

Speculative motive : This demand for money is to invest in the bonds market or fpr other investment purposes. The interest rate influences such demand for money.

Friedman's theory of money demand is different from Keynesian's because of the following reasons:

Friedman believed that money is a part of wealth theory and has different uses other than the three narrow categories defined by Keynesian Friedman unlike Keynesian treats money as asset and not just in the three categories defined by keynesian . he believed that money has a broader use like time deposits.

Also Friedman extended his theory to permanent income but Keynes does not have such distinctions.

Keynesian theory included interest bearing bonds only whereas in Friedman's theory many variables were included like yield on bond or money.

Friedman never divided the money into fixed categories , rather he kept it to be used as per the individual's needs and preferences unlike Keynes which focussed more on idle or active money ie on the categories of speculative , transaction and precautionary money.

2) IS curve represents the conmbinations of interest rate and income when goods market is in equilibrium.

The following is the derivation of IS curve

First graph is the keynesian cross that shows the 45 degree line and the AE curves. As we can see that an increase in any one of the components of AE curve shifts it (here we are assuming that interest rate is rising causing a decline in planned investment and a decline in AE curve from AE2 to AE1.

This leads to a decrease in income from Y2 to Y1.

The IS curve hence shows the inverse relation between income and interest rate.

Slope of IS curve is a positive slope and depends on various factors like

Magnitude of multiplier ie marginal propensity to consume. More the MPC , more would be the increase in investment and a higher equilibrium level of income and this makes the IS curve flatter because now since with the given change in interest rate , the chnage in national income is higher . And in case of smaller size of multiplier the IS curve will be more steep.

Elasticity of investment curve. More the elasticity , more would be the change in investment given a rate of interest , this would increase aggregate demand and hence the level of national income. When investment is inelastic or less elastic then the IS curve is steeper and vice versa.

Shift in position of IS curve

Autonomous expenditure or the AE curve works for the position of IS curve ie when variables like consumption , government spending or investments increase or taxes , the AE curve shifts ,where AE = C+I+G, shifting the IS curves . A decrease or increase in these factors shift the AE curve accordingly.

(You can comment for doubts )