LM curve

10
Money Market and the LM Curve

MACROECONOMICS
Macroeconomics

Prof.
N. Gregory MankiwRudra SensarmaKozhikode
Indian Institute of Management www rudrasensarma info www.rudrasensarma.info ®

PowerPoint Slides by Ron Cronovich
© 2013 Worth Publishers, all rights reserved

Learning objectives & outcomes
• Money Market & the LM Curve
– Real Money, Real Income & Interest Rate y, – Deriving the LM Curve
– Monetary Policy & the LM Curve

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Financial Markets (Money Market) and the LM
Relation
R l i
The interest rate is determined by the equality of the real supply of and demand for money:

M = L (Y , i)
( )
P

Deriving the LM Curve
Deriving the LM Curve
The Effects of an
Increase in Income on the Interest Rate
An increase in income leads to an increase in the demand for money.
Given the money supply, this leads to an increase in the equilibrium interest rate. Deriving the LM Curve
Deriving the LM Curve

Equilibrium in money market implies that increase in income leads to increase in the interest rate.

Plot this relationship between interest rate and income: LM curve.
The LM curve is upward sloping.

Why the LM curve is upward sloping
Why the LM curve is upward sloping
• An increase in income raises money demand
An increase in income raises money demand.
• Since the supply of real balances is fixed, there is now excess demand in the money market at is now excess demand in the money market at the initial interest rate.
• Th i
The interest rate must rise to restore i equilibrium in the money market.

Shifts of the LM Curve
Suppose RBI causes an increase in money supply
(a) The money market

(b) The LM curve

equilibrium i Ms

LM

i

Ms’

LM’ i i'

i
Md
M/P

i'
Y

Y

NOW YOU TRY

Shifting the LM
Shifting the
Shifting the LM curve
• Suppose a wave of credit card fraud causes pp consumers to use cash more frequently in transactions. • Use the money market equilibrium model to show how these events shift the LM show how these events shift the LM curve.

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ANSWERS

Shifting the LM
Shifting the
Shifting the LM curve
( )
(a) Equilibrium in money q y

(b) Th LM curve
The

market

LM’
LM
i'

i’
Md’

i

Md
M/P

i
Y
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Putting the IS and LM relations together: The IS‐LM Model
•Equilibrium iin goods market
E ilib i d k implies that increase in interest rate leads to decrease in output.
•Equilibrium in financial
(money) markets implies that increase in output leads to increase in interest rate.
•When IS curve intersects
LM curve, both goods and financial (money) markets are in equilibrium.

IS relation: Y  C(Y  T )  I (Y , i )  G l i

LM relation:

M
= L (Y) , i)
YL(i
P

Fiscal Policy, Output & the Interest Rate
The Effects of an
Increase in Government
Expenditure

An increase in G shifts th IS curve t hift the to the right, and leads to an increase in the equilibrium level of output and the equilibrium interest rate. i

LM

i' i IS
IS’
IS
Y

Y’

Y

Fiscal Policy, Output & the Interest Rate i LM

The Effects of an
The Effects of an
Increase in Taxes

An increase in T shifts the IS curve t hift th to the left, and leads to a decrease in the equilibrium level of output and the equilibrium interest rate. i

i'
IS
IS’
Y’ Y

Y

Monetary Policy, Output & the
Interest Rate
The Effects of a
The Effects of a
Monetary
Expansion

Increase in M shifts the LM curve to the right, and leads to higher output and a lower interest rate.

When is monetary policy ineffective? IS IS’
1. When investments are driven by ‘animal di b ‘ i l spirits’ i.e. they do not respond to interest respond to interest rates IS curve is vertical
IS curve is vertical
Monetary policy becomes ineffective Fiscal policy needed

i

LM
LM’

i i' Y Y’

Y

When is monetary policy ineffective? i
2. When interest rate is very low,
2 When interest rate is very low people prefer to hold all the money they have
This is known as ‘liquidity trap’ ilow
LM curve is horizontal, monetary
LM curve is horizontal, monetary policy becomes ineffective
Reason why quantitative easing yq g may not work when interest rate is very low
Fiscal policy needed

IS

IS’
LM
Y Y’

Y

Next…
• Macroeconomic Policies in Action
– Policy Mix in the IS‐LM Model
Policy Mix in the IS‐LM Model
– Case Studies

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