LS4.ppt

The Theory of Liquidity Preference due to John Maynard Keynes. A simple theory in which the interest rate is determined by money supply and money demand. Demand for money is made up of: transactions demand for money (increases with Y) speculative demand for money (decreases with r) (M/P)d = L(Y,r) Money Supply The supply of real money balances is fixed: M/P real money balances r interest rate Money Demand Demand forreal money balances: M/P real money balances r interest rate L (r ) Equilibrium The interest rate adjusts to equate the supply and demand for money: M/P real money balances r interest rate L (r ) r1 The LM curve Now let’s put Y back into the money demand function: The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is: Deriving the LM curve M/P r L (r , Y1 ) r1 r2 r Y Y1 r1 L (r , Y2 ) r2 Y2 LM (a) The market for real money balances (b) The LM curve Understanding the slope of the LM curve The LM curve is positively sloped. Intuition: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 the initial interest rate. The interest rate must rise to restore equilibrium in the money market. How ?M shifts the LM curve M/P r L (r , Y1 ) r1 r2 r Y Y1 r1 r2 LM1 (a) The market for real money balances (b) The LM curve LM2 The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium: Equilibrium in the IS-LM Model The IS curve represents equilibrium in the goods market: IS Y r LM r1 Y1 Policy analysis with the IS-LM Model Policymakers can affect macroeconomic variables with fiscal policy: G and/or T monetary policy: M We can use the IS-LM model to analyse the effects of these policies. IS Y r LM r1 Y1 Keynesian Theory Quick Quiz 1 Which of the