Academic journal article Atlantic Economic Journal

Money Demand and the Balanced Budget Theorem

Academic journal article Atlantic Economic Journal

Money Demand and the Balanced Budget Theorem

Article excerpt

In their influential article, Holmes and Smyth [JPE, 1972] propose that the transactions demand for money should depend on tax revenues either through disposable income or through consumption based on theoretical and empirical viewpoints. With such originality, they find that the tax multiplier may be positive.

It is well understood in the macroeconomics literature [Dornbusch and Fischer, Macroeconomics, 1990] that the balanced budget multiplier is unity in a simple Keynesian model but it will be less than unity in an IS-LM model. This note attempts to show that the balanced budget multiplier will be unity in an IS-LM model if the proposal of Holmes and Smyth is adopted.

The IS-LM model is given by:

y = C(y-T) + I(r) + G, 1 [greater than] [C.sub.1] [greater than] 0, [I.sub.1] [less than] 0 (1)

M = L(y- [Theta]T, r), [L.sub.1][greater than]0, [L.sub.2] [less than] 0 (2)

G = T, (3)

where: y = national income; C= consumption; T = tax revenue; I = investment; r = interest rate; G = government expenditure; M = money stock; L = money demand; and [Theta] = index parameter. Equations (1) and (2) represent the economy's IS and LM curves, respectively. Equation (3) states that government spending is entirely financed by tax revenue. …

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