Money Market Equilibrium: The LM Schedule

The Keynesian (II): The IS-LM Model

Muhammad Irwan Ariffin

October 19, 2015

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Outline

1 Introduction

2 Construction of the LM Schedule

3 LM Curve Slope Determinant

4 LM Curve Shift Determinants

Changes in M s
Changes in M d due to Liquidity Preference

5 Conclusion

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 Introduction

The IS-LM Model

Introduction

Three markets:
1 Goods (commodity) market
2 Money market
3 Bonds market
Solve for interest rate and income that simultaneously equilibrate the
goods market and money market (= bonds market):
1 IS combinations of r & Y that equilibrate the goods market
2 LM combinations of r & Y that equilibrate the money market (
do this first!)
Assume other variables are exogenous and fixed: M s , G, T , e

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 Construction of the LM Schedule

Money Market Equilibrium: The LM Schedule

Construction of the LM Schedule

There are two determinants of money demand:

1 Income, Y (positively, due to transaction and precautionary motives)
2 Interest rate, r (negatively, due to speculative motive)
We could express this relationship as (in general form):

M d = L(Y, r) (1)

Or, in linear form:

M d = c0 + c1 Y c2 r c1 > 0, c2 > 0 (2)

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 Construction of the LM Schedule

Money Market Equilibrium: The LM Schedule

Construction of the LM Schedule

Need to find all combinations of Y & r that equilibrate money

demand (L, from equation (1)) with a fixed money supply, M0s
These combinations LM schedule (money demand, L, equals
money supply, M )
For money demand, use equation (2) for simplicity
Money market equilibrium condition, LM schedule:

M0s = M d = c0 + c1 Y c2 r (3)

Refer to Figure 6-5 in textbook

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 LM Curve Slope Determinant

Money Market Equilibrium: The LM Schedule

LM Curve Slope Determinant

What determine the slope of the LM curve (flatter/steeper)?

Consider Y from Y0 to Y1 money market?
M d by c1 Y (where c1 is income-elasticity of M d ):

M d
= c1
Y
r will have to rise to offset the increase in M d
Higher c1 larger M d larger upward adjustment in r needed
steeper LM curve
Whatever change in Y r will adjust to ensure equilibrium in money
market

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 LM Curve Slope Determinant

Money Market Equilibrium: The LM Schedule

LM Curve Slope Determinant

For any Y , how much r has to rise to restore M d to the fixed M s

depends on how elastic (sensitive) money demand with respect to r
The change in money demand for a given change in interest rate:

M d
= c2
r
The r-elasticity of M d determines the slope of M d curve, and
consequently the slope of LM curve
High r-elasticity of M d (M d very responsive to r):
c2 big M d relatively flat
LM curve relatively flat (Figure 6-6b)
Low r-elasticity of M d (M d not so responsive to r):
c2 small M d relatively steep
LM curve relatively steep (Figure 6-6a)
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 LM Curve Slope Determinant

Money Market Equilibrium: The LM Schedule

LM Curve Slope Determinant

Two special cases for LM slope and r-elasticity of M d :

1 M d is perfectly r-inelastic (c2 = 0)

M d curve is vertical (slope = )
LM curve is vertical (the Classical case, where money depends only on
income)
Refer to Figure 6-7 in textbook
2 M d is perfectly r-elastic (c2 )
M d curve is horizontal (slope = 0)
LM curve is horizontal
Refer to Figure 6-8 in textbook

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 LM Curve Shift Determinants

Money Market Equilibrium: The LM Schedule

LM Curve Shift Determinants

Two factors that shift LM curve:

1 Changes in money supply, M0s

Fixed, exogenously decided by central bank
A policy variable
2 Shifts in the money demand function, M d
Changes in liquidity preference
Amount of M d for given levels of income and interest rate, not
changes in M d when income changes!

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 LM Curve Shift Determinants Changes in M s

Changes in M s
LM Curve Shift Determinants

LM schedule: r on the vertical axis, Y on the horizontal axis

M0s = c0 + c1 Y c2 r

Solving for the interest rate:

c0 1 c1 Y
LM : r= Ms + (4)
c2 c2 0 c2
Note that the intercept of LM curve contains M0s (negatively)
A change in M0s will shift the LM curve
If M0s LM shifts to the right (lower intercept)
If M0s LM shifts to the left (higher intercept)
Refer to Figure 6-9 in textbook

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 LM Curve Shift Determinants Changes in M d due to Liquidity Preference

Changes in M d due to Liquidity Preference

LM Curve Shift Determinants

Change in preference towards holding money (which is exogenous),

note that this is not change in income!
Example: Loss of confidence in bonds people prefer to hold money
(more liquid) demand for money goes up while income remains the
same
A change in liquidity preference will shift the M d curve in the money
market:
Initial money demand is M0d (Y0 ) and interest rate is r0
Increase in liquidity preference: M d shifts to the RIGHT from M0d (Y0 )
to M1d (Y0 ) (note: income is unchanged at Y0 )
In the money market: r adjust to reach new equilibrium at r1 (higher)
LM curve shifts to the LEFT
Refer to Figure 6-10 in textbook

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 Conclusion

Conclusion
Money Market Equilibrium: The LM Schedule

1 LM schedule gives the combinations of Y & r that makes the money

market to be in equilibrium
2 LM schedule has a positive slope
3 LM curve is relatively flat (steep) if r-elasticity of M d is high (low)
4 LM curve shifts right (left) with an increase (decrease) in M0s
5 LM curve shifts left (right) with an increase (decrease) in liquidity
preference (demand for money at a given levels of Y & r)

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