Question

Graphically illustrate the Keynesian Transmission Mechanism (which includes the liquidity preference model). What is the purpose of the model? For the graph, draw by hand and scan them or take a picture (i.e. cell phone)) and either insert it into the Word doc or attach them).

Answer 1

Monetary Transmission Mechanism in the Keynesian Theory:

The transmission mechanism in the Keynesian theory is indirect via the interest rate. It is based on the existence of unemployment equilibrium in the economy and on the assumption of short run. In the Keynesian analysis, there are three motives for holding money: precautionary, transactions and speculative.

The demand for money for speculative motive is determined by the interest rate, while the demand for precautionary and transactions motives is determined primarily by the level of income. Given the level of national income, the demand for money is a decreasing function of the rate of interest.

The higher the interest rate, the lower the demand for money and vice versa. This negative relationship between the interest rate and the demand for money provides a link between changes in the money supply and the aggregate variables of the economy.

The Keynesians further believe that money and financial assets (bonds) are good substitutes. They are highly liquid and yield interest. So even small changes in interest rates lead to substitution between money and financial assets. A fall in the interest rate will mean a rise in the price of bonds (or securities) which will induce people to sell bonds and hold more money for speculative purposes.

Given these main elements of the Keynesian theory, its transmission mechanism is explained below:

• In the Keynesian transmission mechanism, changes in the money supply affect aggregate expenditure, output, employment and income indirectly through changes in the interest rate. Suppose the Central bank increases the money supply by open market purchase of government bonds, it lowers the interest rate which, in turn, increases investment and expenditure, thereby raising the national income.
• The mechanism by which changes in the money supply are transmitted into the income level is the asset effect. With income level unchanged, when the money supply is increased, it causes people to spend their excess holdings of money on bonds.
• This means an increase in the demand for bonds and a rise in their prices. A rise in the prices of bonds brings down the money interest rate. This, in turn, increases the speculative demand for money. People prefer to keep money in cash rather than lend it at a low interest rate. This, is called the liquidity effect. This is the first stage in the Keynesian transmission mechanism.
• In the next stage, the fall in the interest rate and an increase in the speculative demand for money stimulates investment. Businessmen prefer to invest in capital goods rather than hold money in cash for speculative purposes.
• In the final stage of the transmission mechanism, the increase in investment raises the level of income through the multiplier process. The increased income generates additional savings equal to the increase in investment and equilibrium will prevail in the commodity market. On the other hand, the rise in real income or output brings diminishing returns to labour, thereby raising per unit labour cost and the price level.
• The Keynesian transmission mechanism consisting of three stages is called the cost of capital channel and is summarised thus: Money →Interest Rate → Investment → Income, where with increase in the money supply, interest rate falls and investment and income rise.
• The rise in price level raises nominal income that leads to an increase in the transactions and precautionary demand for money, thereby bringing a “feedback effect” on the economy. The increase in transactions and precautionary balances, in turn, reduces the speculative balances. The latter raise the interest rate, and bring a fail in investment and income, and lead to a further feedback effect. Friedman calls the feedback effect the income effect.
• The Keynesian transmission mechanism is explained in Fig. 3. Given OI₁ level of investment in Panel (B) of the figure, income is OY, at which savings OS, equal investment OI₁in Panel (A). Panel (C) shows that the interest rate OR, is determined by the equality of money demanded M₁, and money supplied Ms at point E₁.
• It is this rate of interest rate which calls forth the level of investment OI₁ with which we started. Now the rise in the money supply to Ms₁ brings a fall in the interest rate to OR₁, a rise in investment to Ol₂ and a rise in income to OY₂. Thus equilibrium is restored in the circular flow. The feedback process is not shown in the figure to keep the analysis simple. This is how the effects of an increase in the money supply are transmitted to the real variables of the economy under the Keynesian transmission mechanism.

Its Weaknesses: :

• The transmission mechanism explained above is neither smooth nor reliable because the velocity of money is not assumed as stable in the Keynesian theory. For example, when the money supply is increased by the monetary authority, this increases liquidity with the public. People may want to hold it rather than spend it. In such a situation, when the money supply increases, the interest rate falls. But the demand for money is insensitive to the change in interest rate.
• The investment and income remain unaffected. The velocity of circulation of money falls. This is the Keynesian liquidity trap at a very low interest rate, people prefer to keep money in cash even with an increase in the money supply rather than invest it.
• As a result, the money supply does not affect national income. Figures 3 and 4 depict these cases. Fig. 4 shows that with a liquidity trap when the money supply increases from Ms to Ms₁ at the interest rate OR, the EE, portion of the LP curve is perfectly elastic.
• Again, when the money supply increases from Ms to Ms₁, it is held by the people and not spent. As a result, the LP curve is horizontal and the IS curve intersects it at point E in Fig. 5. There is no change in equilibrium income OY and interest rate OR. Keynes himself accepts the weakness of his transmission mechanism when he explains the liquidity trap.

The transmission mechanism also does not operate smoothly by the expectations of money holders over future interest rates. These are highly volatile. The demand for money curve shifts with changes in expectations. This is illustrated in Fig. 6 which extends the explanation of Panel (c) of Fig. 3.

The increase in the money supply to Ms₁ brings a fall in the interest rate from OR, to OR₂, given the demand for money Md₁. But a rise in future expectations shifts the MD curve to the right to MD₁ due to increase in the speculative demand for money. This raises the interest rate to OR₃ with increase in the money supply to Ms₁.

Another factor which inhibits the smooth operation of the Keynesian transmission mechanism is the interest rate elasticity of investment. The less elastic is the investment curve, the less is the increase in investment as a result of a fall in the interest rate, and vice versa. This is illustrated in Fig. 7 where the 7D, curve in Panel (A) is less elastic. When the interest rate falls from OR, to OR₂ investment increases by I₁ I₂ which is less than increase in investment I₃I₄ when the investment curve ID₂ is elastic in Panel (B).