Question

Keynesians reject the influence of monetary policy on the economy. One argument supporting this Keynesian view is that the a. money demand curve is horizontal at any interest rate. b. aggregate demand curve is nearly flat. c. investment demand curve is nearly vertical. d. money demand curve is vertical.

Short answer

The argument that supports the Keynesian view of rejecting the influence of monetary policy on the economy is that the investment demand curve is nearly vertical (option c). This is because, in Keynesian economics, businesses base investment decisions more on expectations of future profits, not changes in interest rates which makes the investment demand curve inelastic (nearly vertical). Thus, changes in interest rates influenced by monetary policy have minimal effect on investment.

Step-by-step solution

Understand the Keynesian Economics

Keynesian economics is primarily based on the idea that in the short term, especially during recessions, economic output is influenced more by aggregate demand (total spending in the economy) than by the supply of money in the economy. According to Keynesians, changes in aggregate demand, whether anticipated or unanticipated, have an influence on real output and employment, but not on prices.

Analysing Each Statement

(a) Money demand curve is horizontal at any interest rate: A horizontal money demand curve suggests that changes in the interest rate have no effect on the quantity of money demanded. This viewpoint doesn't align with Keynesian theory, which asserts that interest rates can impact investment spending. (b) Aggregate demand curve is nearly flat: A nearly flat aggregate demand curve implies that changes in price levels have little impact on aggregate demand. While Keynesians believe that changes in aggregate demand can affect real output and employment, they do not assert that the aggregate demand curve is nearly flat. (c) Investment demand curve is nearly vertical: In Keynesian economics, the investment demand curve can be steep, indicating that changes in interest rates will have little effect on investment. This is because Keynesians believe that businesses make investment decisions based largely on expectations of future profits, not changes in interest rates. (d) Money demand curve is vertical: This suggests that changes in the interest rate have no effect on the quantity of money demanded, an assertion that is not part of Keynesian economics.

Conclude The Correct Answer

The investment demand curve being nearly vertical is the argument supporting the Keynesian view that monetary policy does not significantly influence the economy (option c). According to Keynesian theory, businesses base investment decisions more on profit expectations than interest rates, causing the investment demand curve to be inelastic (nearly vertical). This suggests that changes in interest rates, which are controlled by monetary policy, have little effect on investment, supporting the Keynesian rejection of the influence of monetary policy on the economy.

Key concepts

Aggregate Demand

In the realm of Keynesian economics, the concept of aggregate demand is pivotal. It encapsulates the total amount of goods and services that all the different components in an economy (households, businesses, government, and foreign buyers) are willing to purchase at any given price level. According to Keynesian theory, the level of aggregate demand is crucial for determining the overall economic activity, especially during periods of recession.

When aggregate demand increases, it can lead to higher output and employment in the short run. Contrary to the idea that a nearly flat demand curve characterizes Keynesian thought, Keynesians accept that while the curve may not be perfectly flat, it tends to be downward sloping, indicating that higher price levels can reduce demand, albeit not as significantly as the classical model suggests.

Monetary Policy

Keynesian economists hold a distinctive view on the efficacy of monetary policy. They argue that monetary policy, which involves the manipulation of the money supply and interest rates by a central bank, has limited power in influencing real economic variables such as output and employment.

Instead, they emphasize fiscal policy—government spending and taxation—as a more reliable tool for managing economic fluctuations. Keynesians argue that during a recession, an increase in money supply does not necessarily lead to an increase in spending since the prevailing pessimistic expectations and uncertainty may dampen the efficacy of interest rate manipulations.

Therefore, while non-Keynesians may view monetary adjustments as a way to stimulate investment and consumption, Keynesians are more skeptical about the direct impact such policies have on actual economic activity.

Investment Demand Curve

The investment demand curve, in Keynesian analysis, represents the relationship between the quantity of investment demanded by businesses and the interest rate. This framework proposes that at high interest rates, the cost of borrowing is higher, which makes investments less attractive. However, Keynesians argue that the curve is relatively inelastic or nearly vertical, reflecting their belief that the interest rate is not the primary factor that companies consider when deciding to invest.

The main determinant, according to Keynesians, is the expected rate of return from the potential investment compared to the cost of investment, which is more influenced by macroeconomic outlook and business confidence. Hence, even substantial changes in the interest rate may not significantly alter investment levels, reinforcing the Keynesian perspective that monetary policy plays a minimal role in affecting real investments.

Money Demand Curve

The money demand curve is a graphical representation of the demand for money according to different interest rates. In non-Keynesian models, this curve is typically downward sloping, indicating that as interest rates fall, the demand for money increases, since people prefer holding cash when returns on savings are low.

However, Keynesian economics suggests a different view. Although Keynesians do not claim that the money demand curve is perfectly inelastic (vertical) or perfectly elastic (horizontal), they do believe it can be fairly flat at the lower bound; meaning that when interest rates are near zero, demand for liquidity can increase sharply. In regular circumstances, the curve is more elastic. This distinction underscores the Keynesian perspective that interest rates may have a limited effect on the money demand during certain economic conditions, particularly when the economy is in a liquidity trap.