Deriving LM Curve and Introducing

Equilibrium in Goods and Money Market

Macroeconomics
Session 9
 The Demand for Money: Motives
• Keynes’s famous three motives for holding money:

– The transactions motive, which is the demand for money

arising from the use of money in making regular payments

– The precautionary motive, which is the demand for money

to meet unforeseen contingencies

– The speculative motive, which arises from uncertainties

about the money value of other assets that an individual
can hold
Transaction and precautionary motives → mainly discussing M1
Speculative motive → M2, as well as non-money assets
15-2
 Transaction Demand
• Due to lack of synchronization of receipts and
disbursements
– keep money on hand to make purchases between pay
periods

• There is a tradeoff between the amount of interest an

individual forgoes by holding money and the costs of
holding very small amount of money
– Benefits of keeping very small amounts of money is higher
interest/yield earned on assets kept in form bonds
• The real money demand would negatively depend on the
opportunity cost of holding M3: the difference between treasury
rate and the deposits constituting M3
– Cost of keeping very small amounts of money is the cost
and inconvenience of frequent transactions to convert
bond into money
15-3
 The Precautionary Motive
• People are uncertain about the payments they
might want or have to make → there is demand
for money for these uncertain events
• Cab on a rainy day

• The more money a person holds, the less likely he

or she is to incur the costs of illiquidity
• Added consideration is that greater uncertainty about
receipts and expenditures increases the demand for money
– Salaried vs non-salaried person

15-4
 Speculative Demand for Money
• Focuses on the store-of-value function of money →
money in the investment portfolio of an individual
• Wealth held in specific assets → portfolio
– Due to uncertainty, unwise to hold entire portfolio in a
single risky asset → diversify asset holdings
• Money is a safe asset, but gives zero nominal interest
rate.
– Demand for money depends upon the expected yields
(opportunity cost) and riskiness (expectation of change in
yield i.e. price) of other assets (James Tobin)
 Increase in the opportunity cost of holding money lowers money
demand
 Increase in the riskiness of the returns on other assets increases
money demand (Cash is king !!)

15-5
Money and Transaction Demand for Money

• Money Supply
– Monetary based created by the central bank,
– Money multiplier impacted through reserve ratio

• Transaction Demand for Money

– Decreases with the interest rate
– Increases with the transactions cost of converting bond
into money
– Increases with income
 The Money Market and the LM Curve
• The LM curve shows combinations of interest rates and levels of output
such that money demand equals money supply  equilibrium in the
money market

• The LM curve is derived in two steps:

1. Explain why money demand depends on interest rates and income
2. Equate money demand with money supply, and find combinations of income
and interest rates that maintain equilibrium in the money market
– (i, Y) pairs meeting this criteria are points on a given LM curve
 Demand for Money
• The demand for money is a demand for real money balances
– People are concerned with how much their money can buy, rather than the
number of dollars in their pockets
• The demand for real balances depends on:
─ Real income (Y): people hold money to pay for their purchases, which, in turn,
depend on income
─ Interest rate (i): the cost of holding money

• The demand for money is defined as: L  kY  hi

 Y2> Y1
i

Interest rate

k∆Y

L2=kY2-hi

L1=kY1-hi

0 Demand for money (M/P) L

DEMAND FOR REAL BALANCES AS A FUNCTION OF THE INTEREST RATE AND REAL
INCOME
 Demand for Money
L  kY  hi
• The parameters k and h
reflect the sensitivity of
demand for real balances to
the level of Y and i
• The demand function for
real balances implies that
for a given level of
income, the quantity
demanded is a decreasing
function of i
• Higher value of k will lead to
larger parallel shift in demand
for money for a given change
in income
• Higher value of h will make
the money demand curve
flatter
 The Supply of Money

• The nominal quantity of money supplied, M, controlled by central bank

ሜ
– Real money supply is 𝑀
𝑃ሜ
– where M and P are assumed fixed

– We will see the impact of relaxing these assumption in coming sessions

 Money Market Equilibrium Derivation of the LM Curve
i i

LM

E2 E2
i2
Interest rate

i2
L2=kY2-hi

Interest rate
i1 E1 E1
i1
L1=kY1-hi

L Y1 Y2 Y

M̅/P̅
Income, output
Real balances

Panel (a) shows the money market.

The supply of real balances is the Panel (b) shows combinations of
vertical line M̅/P̅ . L1 and L2 i and Y such that demand for
represent money demand at real money balances exactly
different levels of income (Y1 and matches available supply
Y2).
 Money Market Equilibrium Derivation of the LM Curve
i i

LM

E2 E2
i2
Interest rate

i2
L2=kY2-hi

Interest rate
i1 E1 E1
i1
L1=kY1-hi

L Y1 Y2 Y
M̅/P̅
Real balances Income, output

Starting at Y1, the corresponding Point E1 is recorded in panel

demand curve for real balances is (b) as a point on the money
L1  shown in panel (a) market equilibrium schedule,
Point E1 is the equilibrium point in or the LM curve
the money market (i1, Y1) pair is a point on LM
curve
 Money Market Equilibrium Derivation of the LM Curve
i i

LM

E2 E2
i2
Interest rate

i2
L2=kY2-hi

Interest rate
i1 E1 E1
i1
L1=kY1-hi

L Y1 Y2 Y
M̅/P̅
Real balances Income, output

• If income increases to Y2, demand for real money balances higher at every level of
i  money demand shifts to L2
– The interest rate increases to i2 to maintain equilibrium in money market
– The new equilibrium is at point E2
• Record E2 in panel (b) as another point on the LM curve
– Pair (i2, Y2) is higher up the given LM curve
 Money Market Equilibrium and the LM Curve

• The LM schedule shows all combinations of interest

rates and levels of income such that the demand for
real balances is equal to the supply  money market is
in equilibrium
– LM curve is positively sloped:
 For a fixed money supply, a rise in income leads to a rise in money
demand
 To maintain the demand for real money balances equal to the fixed
supply, the interest rate must rise

Money market equilibrium implies that an increase in the interest

rate is accompanied by an increase in the level of income.
a rise in income leads to rise in demand for money, thus raising the interest rate
at given money supply
 The Supply of Money, Money Market
Equilibrium, and the LM Curve
• The LM curve can be obtained directly by combining the demand curve for
real balances and the fixed supply of real balances
– For the money market to be in equilibrium, supply must equal demand:
M
 kY  hi
P

– Solving for i: 1 M
i   kY  
h P

The relationship is the LM curve.

 Impact of k (sensitivity of demand for real balances to the level of Y)

i i
k’>k
Y2> Y1
LM
E’2 E’2
i’2 i’2

E2
i2 L1=k’Y2-hi i2
Interest rate

E2
L2=kY2-hi

Interest rate
E’1
E’1 i'1
i'1
i1
E1 L1=k’Y1-hi i1 E1
L1=kY1-hi

L Y1 Y2 Y

M̅/P̅
Income, output
Real balances

Panel (a) shows the money market. The supply of real balances is the vertical line M̅/P̅.
L1 and L2 represent money demand at different levels of income (Y1 and Y2).

Panel (b) shows combinations of i and Y such that demand for real money balances
exactly matches available supply
 Impact of h (sensitivity of demand for real balances to interest rate)
i i
LM
k∆Y
h’> h
i2 E2 Y2> Y1 E2
Interest rate

i2

Interest rate
i1 E1 L2=kY2-hi E1
i1
L1=kY1-hi

M̅/P̅
L Y1 Y2 Y
Real balances Income, output
i
i

Interest rate
LM
Interest rate

E2
i2 E2 i2
E1 L’2=kY2-h’i i1 E1
i1
k∆Y
L’1=kY1-h’i Y1 Y2 Y
M̅/P̅ L Income, output
Real balances
 The Slope of the LM Curve
1 M
i   kY  
h P
• If the money demand is highly responsive to income (k is higher), then
the LM curve will be steeper because rise in income will raise money
demand and interest rates (more due to higher k)

• If the money demand is highly sensitive to interest rate (h is large) then

LM curve will be flatter because a rise in income causes (lesser) rise in
money demand due to higher sensitivity of money demand to interest
rate (h is large)

• If the money demand is insensitive to interest rate (h is small) then LM

curve will be steeper because
 The Position of the LM Curve:
Shift of the LM Curve Due to Change in Money Supply

i i
ഥ
𝑀
∆ LM
𝑃
L2=kY2-bi
E2 LM’
i2 i2
E2
L1=kY1-bi E4
E4
Interest rate

∆𝑌

Interest rate
i1
E1 i1
E1
E3 E3

ഥ Y1 Y2 Y
𝑀 𝑀′ L

𝑃 𝑃 Income, output
Real balances

How money supply can be changed?

How will factors other than interest rate affecting demand for money (precautionary
demand, transaction cost, etc.) will impact the money market equilibrium and LM curve?
 The Position of the LM Curve
i i
ഥ
𝑀
∆ LM
𝑃
L2=kY2-bi
E2 LM’
i2 i2
E2
L1=kY1-bi E4
E4
Interest rate

∆𝑌

Interest rate
i1
E1 i1
E1
E3 E3

ഥ Y1 Y2 Y
𝑀 𝑀′ L

𝑃 𝑃 Income, output
Real balances

• Real money supply constant along the LM curve  a change in the real money
supply will shift the LM curve
– Panel (a) shows the demand for real money balances for income level Y 1
– Notice the impact of increased money supply in the figure
𝑀ሜ
 For the money supply , equilibrium occurs at point E 1 with interest rate i1 
𝑃ሜ
corresponding point E1 on the LM curve
 The Position of the LM Curve
i i
ഥ
𝑀
∆ LM
𝑃
L2=kY2-bi
E2 LM’
i2 i2
E2
L1=kY1-bi E4
E4
Interest rate

∆𝑌

Interest rate
i1
E1 i1
E1
E3 E3

ഥ Y1 Y2 Y
𝑀 𝑀′ L

𝑃 𝑃 Income, output
Real balances
• Notice the impact of increasedሜ money supply in the figure
𝑀
 For the money supply ሜ , equilibrium occurs at point E1 with interest rate i1 
𝑃
corresponding point E1 on the LM curve
ሜ
𝑀′
• If real money balances increases to ሜ , money supply curve shifts to the right
𝑃
– To restore equilibrium at the income level Y1, the i must decrease too
– In panel (b), the LM curve shifts to the down and to the right
 Equilibrium and the Goods
and Money Market
• The IS and LM
schedules summarize
the conditions that have
to be satisfied for the
goods and money
markets to the in
equilibrium (given the
exogenous variables:
money supply, fiscal
policy) E3

Flat SRAS curve

 i i

LM

E2 E2
i2
Interest rate

i2
L2=kY2-hi

Interest rate
i1 E1 E3 E1 E3
i1
L1=kY1-hi

L Y1 Y2 Y

M̅/P̅
Income, output
Real balances

Notice that Demand for Money is higher than the Supply at Point E3
 Equilibrium and the Goods
and Money Market
• The IS and LM
schedules summarize
the conditions that have
to be satisfied for the
goods and money
markets to the in
equilibrium (given the E4
exogenous variables:
money supply, fiscal
policy)

Flat SRAS curve

 AD AD=Y

Aggregate demand
E2 Ā+c(1-t)Y-bi2

Ā-bi2 Ā+c(1-t)Y-bi1
i2< i1
E4
Ā-bi1 E1

Y1 Y2 Y
Income, output
(a)
i
E4
Interest rate

i1 E1

i2 E2

IS
Y1 Y2 Y
Income, output (b)
DERIVATION OF THE IS CURVE
 Equilibrium and the Goods
and Money Market
• The IS and LM
schedules summarize
the conditions that have
to be satisfied for the
goods and money
markets to the in
equilibrium (given the
exogenous variables:
money supply, fiscal
policy)
• Assumptions:
– Price level is
constant
– Firms willing to
supply whatever
amount of output is
demanded at that
price level

Flat SRAS curve

 Changes in the Equilibrium Levels of Income
and the Interest Rate
No ceteris paribus

• The equilibrium levels of

income and the interest rate
change when either the IS or
the LM curve shifts
• Figure shows effects of an
increase in autonomous
spending
– Shifts IS curve out by 𝛼𝐺 Δ𝐺 if
autonomous government
purchases is the source of
increased spending
– The resulting change in Y is
smaller than the shift in the
IS curve
Reason The slope of LM curve
A rise in autonomous spending leads to a rise in Y, but the rise in Y raises
money demand and interest rate, which reduces investment demand