Econ 100b

Created 4/30/1996
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Lecture Ten

Investment, Saving, and Liquidity Preference
(Economics 100b; Spring 1996)

Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net

February 12, 1996


Short-Run and Long Run; Fixed vs. Flexible Prices
Investment and Savings
What If Quantities Adjust, and Not Prices?
Liquidity Preference
Problem: the Interest Rate Is Trying to do Two Things at Once

Short-Run and Long Run; Fixed vs. Flexible Prices

So far we have either dealt with models in which there is no contact with the price level--like the long-run, full-employment model of chapter 3--or with models (like chapter 6) where shifts in spending (due, in this case, to jumps in the money stock at constant velocity of circulation) show up one-for-one in shifts in a flexible overall price level.

Lots of handwaving; lots of talk about forces pushing the economy toward equilibrium; lots of talk about how if all expectations are satisfied, and so forth.

John Maynard Keynes had something important to say about this--that this kind of long-run analysis was insufficient:

"Now 'in the long run' this [way of summarizing the quantity theory of money] is probably true.... But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again."


This week we make the polar opposite assumption to that of a perfectly flexible price level (and perfect competition); this week we assume a fixed price level (at least within the time span covered by this week's models) and that firms are quantity constrained.

Why make this polar opposite assumption?


Investment and Savings

Recall our formula for balance in the market for goods and services, for the equilibrium distribution of output between investment, production, and government uses:

Sp = DEF + I(r)

Equilibrium in the financial markets; in the market for loanable funds. And recall the argument made--that r would shift because of excess supply or excess demand of bonds in order to bring private savings into equality with the deficit plus desired investment.


What If Quantities Adjust, and Not Prices?

All this assumed--implicitly--that production continued at its normal pace as this equilibrating process worked itself out. Suppose not. Suppose that we shift ourselves into a model in which the price level is fixed,a nd businesses are quantity constrained. Suppose then we discover that:

Sp > DEF + I(r)

What happens?

Well, let's call Y* = F(K, L) "full employment" output--the level of output generated by the long-run full-employment model, in which firms hire as many workers and finance as much capital as they want and sell as much as they produce. You have I(r) in funds being raised on the capital markets and committed to fixed investment. You have G being spent on goods and services. And you have private consumption:

Y* - T - Sp < Y* - I(r) - G

Desired consumption spending (by consumers) is less than the supply of consumer goods produced by businesses.

In a flexible-price model, the price of consumption goods would fall...

Net impact? The equation:

Sp > DEF + I(r)

is satisfied, but not necessarily by r adjusting. Instead, income falls.

And we get the I-S curve; the investment-savings relation; that if (conditional on fiscal policy; other shocks to the economy; investors' animal spirits; the consumption function; and so on) interest rates are such and so, then firms' reactions to unplanned inventory accumulation (or decumulation) will shift Y until the market for loanable funds is once again brought into equilibrium--but at a different level of output and income Y for each possible interest rate r.

Figure: IS Curve

Expand government spending, or cut taxes, or make investors animal spirits more optimistic, and move the IS curve out to the right...

Why didn't we see this possibility--this range of equilibria in the loanable funds market--when we were running through chapter 3? Because we didn't allow for the possibility that firms could be demand constrained: we didn't allow them to cut back production in cases where they found themselves not selling their output...

In this sense--allowing for adjustment to proceed through quantity shifts as well as and in place of price shifts--the theory and models laid out here is a more General Theory than the full-employment long-run model of chapter 3.

And that is why it is no accident that John Maynard Keynes called his 1936 book The General Theory of Employment, Interest, and Money.


Liquidity Preference

OK. So now that we allow firms to adjust by shifting output, we have not one point-of-rest for the economy, but a whole bunch: a different level of output Y for every interest rate r.

How do we pin down where the economy is at any given short-run moment?

The cost of holding "money"--in the form of cash, or in the form of assets that pay a lower yield because of their "liquidity":

(M/P)d = L(i, Y)

The higher the nominal interest rate i, the more "expensive" it is in some sense to hold money. The higher is output and spending Y, the more money you want to hold. Note that the quantity theory is just the special case:

L(i, Y) = Y/V

Now that the price level is fixed at its initial P; and the nominal stock of "money" is fixed by government monetary policy, we can see that:
(M/P)d = L(i, Y) Is going to give us a bunch of (i, Y) points that correspond to equilibrium in the money market. Along this line, interest rates are high enough to reduce households' and firms' desired holdings of real money balances to the stock available if output is as given on the horizontal axis. Figure: LM curve Expand the real money supply, and shift the LM curve out to the right... Why didn't we see this LM curve back when we studied inflation? Flexible prices again--invariant V and flexible P gave us a vertical LM curve, implicitly, at Y=Y*.
Problem: the Interest Rate Is Trying to do Two Things at Once i is a short-run, nominal interest rate; r is a long-run, real interest rate. Complex relation between them. We'll take a look at it later. For now, cut the Gordian knot and say that inflation is zero, and that monetary policy not expected to change, so i = r Then the requirement both that the market for loanable funds be in balance--that investment equals savings--and that demand for liquidity equal the money stock (note: I, S, L, M) get us to a single point: Figure: IS-LM equilibrium This is not necessarily a good point to be at. It can have massive unemployment. It can imply massive over demand for the economy's limited resources (hence, accelerating inflation). But it is the short-run equilibrium we get. It is the short run equilibrium we get because the interest rate:

At full employment output Y*, the interest rate could do one of these tasks, easy; but it can't do both of them except by luck or by skill



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Econ 100b

Created 4/30/1996
Go to
Brad DeLong's Home Page


Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net/