Friday, May 13, 2011

Synthesis of Monetary and Income Analysis - Part I

IS-LM Analysis - Commodity Market and Money Market Equilibrium

Macro Economics deals with the fundamental problems, which are concerned with determination of gross domestic output, income and employment, price level, and growth of national income. In the short-run determination of income, employment and price level are the primary concerns. Government policies, necessary to control these variables, are required to be ascertained, and put into use at the right time to accelerate or retard the economy.

Keynesian analysis is known as Income Analysis. The Monetary Analysis was done by classical economists. But this is actually a sysnthesis of Keynesian economics.

Economists Hicks and Hansen designed a model, which is popularly known as the Hicks-Hansen IS-LM Analysis. Assumptions of this analysis are as follows.

1. An economy consists of four types of markets, namely commodity market, money market, securities market and labour market.
2. There are enough resources available to produce the required quantity of goods and services, in accordance with the demand.
3. Any change in demand is reflected in a change in output.
4. Aggregate demand or expenditure consists of consumption expenditure, investment expenditure and government expenditure.
5. Aggregate supply consists of consumption goods and savings. To this we add tax collected (T), which is the income of the government.

I) Income Analysis - This is done in the commodity market. II) Monetary analysis - This is done in the money market.

Commodity market equilibrium condition
1. Consumption Function

'a' is the minimum level of consumption even at zero income. The income identity is Y = C + S (income = consumption + savings)
C = a + b*Y
Or, C = a + (ΔC / ΔY)*(Y)
Y = disposable income

2. Savings Function

s = ΔS / ΔY

3. Investment Function

Investment (I) = f(r), where 'r' is the rate of interest. Investment is inversely related to the rate of interest, as rate of interest is the cost of borrowing investment money.
This shows the equilibrium condition in the commodity market. The commodity market is said to be in equilibrium when the economy spends as much as it earns, or when income is equal to expenditure. That means when the supply side Y = the demand side E.
Y = E Or, C + S = C + I
C cancels out from both the sides of the equation, leaving S and I on either side, which are equal. That is, S = I (savings = investment)

Money Market Equilibrium condition

Demand function for money or Money-Demand function is Md = KPY + L(r)
where Md = demand for money
P = Price Level
Y = money income (gross national product)
PY = National Income or the money value of the goods and services produced. It is the real income.
K = proportion of money that is held for transactions purpose and precautionary purpose.
Transaction demand and precautionary demand depend upon the level of income. If the income increases, the demand for money also increases. Any increase or decrease in the rate of interest is unable to influence these two demands for money. Only speculative demand for money is influenced by the rate of interest.

"L" = Speculative demand for money or Liquidity Preference (that is, preference to keep liquid cash). 'L' is a function of the rate of interest. That is, L = f(r)
Suppose an individual is initially at point A. He is holding OMo amount of money, when the rate of interest is Oro. Money holding means the sacrifice of the current rate of interest. If the rate of interest goes up, an individual reduces his money holding, in order to earn the high rate of interest. Therefore, the rate of interest is called the opportunity cost of holding money, i.e. loss of the opportunity to earn interest at the current rate. Higher the rate of interest, higher is the opportunity cost of holding money, and consequently lower is the demand for money. People will then want to maintain their wealth in the form of bonds and securities.

Money Supply curve
Ms = C + D
C = currency in circulation in the form of notes and coins.
D = deposit or bank money
Money supply, Ms, remains fixed in the short-run, as it is controlled by the Central Bank, the central monetary authority. Equilibrium condition in the money market is established when Md = Ms (demand for money = supply of money).

Part I - of IV | Part II - Derivation of the IS Curve

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