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?
- Because in large part the price level is fixed.
- Coordination problems.
- Institutional and other differences.
- Next week we think about intermediate situations--overall price level
neither completely flexible nor completely fixed--when we talk about aggregate
supply.
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...
- Here, instead, we see that inventories rise: unplanned inventory
accumulation takes place. As a result, businesses cut back on production.
- As they cut back on production, the flow of income Y falls below
Y*...
- As the flow of income Y falls, Sp falls as
well.
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:
- is the cost of liquidity preference, and as such must balance
the stock of liquid assets with households' and firms' desires to hold
them.
- is the marginal efficiency of investment, the signal that tells
firms where to cut off their investment plans because the marginal investment
is not worth its financing cost.
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
- later on we will see that the wedge between i and r doesn't help solve
this dilemma (although it does greatly complicate life)...
