Deriving the LM curve Shifts in LM curve

Deriving the LM curve Shifts in LM curve

LM Curve LM curve shows the interest rate and income when the money market is in equilibrium L stands for Money Demand M stands for Money Supply Money Market: Real money supply: MS/P • Assume the central bank (Fed) fully controls MS • P is the price level (assumed to be constant in short run) • Does not depend on the interest rate Real money demand primarily depends on: • Interest rate: Higher interest rate reduces money demand (higher • opportunity cost of keeping money in wallet or checking account) Income: Higher income increases money demand (higher income more stuff bought need more money)

LM Curve Equilibrium in the money market: Real money supply= Real money demand Interest rate Real money supply Equilibrium interest rate Real money demand Real money supply Money demand is drawn given a certain level of income

LM Curve Example: Computing the equilibrium interest rate in the money market MD =2000 – 200*r MS=5000 P=5 Money Demand Nominal Money Supply Price level Set MD=MS/P and solve for r: 2000 – 200*r = 5000/5 r = 5 (5%)

LM Curve The LM curve is derived by plotting real money demand for different levels of income and looking at the resulting equilibrium • Starting at equilibrium, suppose income rises, so real money demand increases • If interest rate does not rise (point B) money demand is greater than the supply of money • Interest rate must rise to make money demand equal to money supply

LM Curve The LM curve shows the combinations of the real interest rate and income that clear the money market (MS=MD) • Intuitively, for any given level of output, the LM curve shows the interest rate necessary to equate real money demand supply • Thus the LM curve slopes upward from left to right

LM Curve Example: Deriving an equation for LM curve MD = Y – 200*r MS=5000 P=5 Money Demand Nominal Money Supply Price level

LM Curve and Shifts Factors that shift the LM curve Change in money supply or the price level • Any change that reduces real money supply relative to real money demand shifts LM curve up • For a given level of income, the reduction in real money supply relative to real money demand causes the equilibrium real interest rate to rise • The rise in the real interest rate is shown as an upward shift of the LM curve • Similarly, a change that increases real money supply relative to real money demand shifts LM curve down and to the right

LM Curve and Shifts Increase in the real money supply shifts LM down and to the right) (MS increases or Price level decreases)

LM Curve and Shifts • A reduction in real money supply shifts the LM curve up and to the left • The real money supply changes when the nominal money supply changes at a different rate than the price level

LM Curve and Shifts Factors that shift the LM curve Changes in real money demand • An increase in real money demand shifts the LM curve up and to the left • Similarly, a reduction in real money demand shifts the LM curve down and to the right

LM Curve and Shifts Increase in real money demand shifts LM up and to the left) Intuitively: Increase in money demand (holding income fixed at 4000) leads to an increase in the interest rate so that MD=MS LM 2 now shows the interest rate and income where the money market is in equilibrium given this increase in money demand

LM Curve and Shifts Summary of the factors that shift the LM curve • LM curve shifts down and to the right because of • an increase in the nominal money supply by the Fed (M S) • a decrease in the price level (P) • a decrease in money demand due to: • an increase in expected inflation • an increase in the efficiency of payment technologies (like ATM cards) • LM curve shifts up and to the left when the opposite happens to the factors listed above

LM Curve and Shifts If you are not sure whether LM shifts up/left or down/right: • Use the money market graph to identify what must happen to the interest rate (holding income fixed) when something changes. • If the interest must rise LM shifts up/left • If the interest must fall LM shifts down/right End of slides

LM Curve The LM Curve: Summary • LM curve shows r & Y such that real MS= real MD • Any change to real MS or real MD will shift the LM curve End of slides