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Lecture 7

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McGill University
Economics (Arts)
ECON 460
William Watson

Lecture 7 Thursday, September 27, 2012 Chapter 14: The Classical Theory of the Rate of Interest 
 Check Marshall, Cassel, Carver, Flux, Taussig, Walras: I(r) = S(r) “Self-regulatory process of adjustment which takes place without the necessity for any special intervention or grandmotherly care on the part of the monetary authority.” “Unlike the neo-classical school, who believe that saving and investment can be actually unequal, the classical school proper has accepted the view that they are equal.” (Is Marshall classical or neoclassical?) If Y is assumed given, does r equate I and S and is the classical view reasonable? How does Keynes characterize the assumption that I and/or S can shift with no effect on Y? How could they save their story using an automatic change in the wage-unit? What’s going on in the diagram? (Which would we typically put on the vertical axis, r or I?) What are the X and Y curves? Do shifts in these curves cause changes in r? Where does r come from?
Given r and given I, do we know which Y-curve must come to be? Why or why not? “The wild duck...” (From Ibsen play of that title.) Appendix to Chapter 14: Appendix on the Rate of Interest in Marshall’s “Principles of Economics,” Ricardo’s “Principles of Political Economy,” and elsewhere Please skip. X: investment curve Y: saving higher interest rate, the less investment higher interest rate, the more saving with income given, changes in r have effect on saving but the main determinant of saving is the level of income and its not enough to know level of r but if there is change of savings curve: you are lost, not enough information to know level Chapter 15: The Psychological and Business Incentives to Liquidity (Business can’t by psychological?) I What is the income-velocity of money?  Speed at which money changes hands What did the “quantity theory of money” say? (MV=Py) Where does the demand for money come from? (Doesn’t everyone have an infinite demand for money?) Income-motive?
Precautionary motive?
Speculative-motive. Where monetary management can have its effect. Why? Speculative-motive “shows a continuous response to gradual changes in the rate of interest.” Banking system can usually always buy or sell bonds for money. Why is that important? Distinguish changes in r resulting from ΔM vs. ΔL. (Open market operations can work through both. How?) ΔL can be discontinuous, causing discontinuous Δr. If everyone reacts to news in same way, r will change without need for trading; if differently, r and M will both change. II M = M 1 M2 = L (1) + L (2) i. Relation of ΔM to Y and r. How does M change? Gold-mining? Printing money? Either way, Y rises. Does income-motive absorb all the new M? ii.1 (Y) = Y/V = M1. In short run, V more or less constant. iii. M2 does not depend on absolute level of r but on “what is considered a fairly safe level of r.” Explain. How does a declining r increase the riskiness of illiquidity? Increases likelihood of capital loss “It is evident, then, that the rate of interest is a highly psychological phenomenon.” Monetary policy can fail if it is seen as experimental: M2 can “increase almost without limit in response to a reduction of r below a certain figure.” r “highly conventional ...phenomenon.” Actual value largely governed by prevailing view of its expected value. It may fluctuate for decades above level consistent with full employment (emphasis supplied).  Conventional: we know what r should be “The difficulties …”- Gradually getting the public used to the idea of lower rates is possible, however: Britain after leaving gold. III If central bank bought and sold all types of securities it would influence the whole complex of r’s. Mainly only influences short end. Limitations on monetary authority’s influence: 1
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