Lectures 7 & 8

Building The
IS-LM Model:
A Recap
Macroeconomic Theory

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 The Money Market & the LM Curve
The Theory of Liquidity Preference
• The LM curve plots the relationship between the interest rate and the level
of income that arises in the market for money balances.
• To understand this relationship, we begin by looking at a theory of the
interest rate, called the theory of liquidity preference.
• In his classic work The General Theory, Keynes offered his view of how the
interest rate is determined in the short run.
• His explanation is called the theory of liquidity preference because it posits
that the interest rate adjusts to balance the supply and demand for the
economy’s most liquid asset—money. Just as the Keynesian cross is a building
block for the IS curve, the theory of liquidity preference is a building block for
the LM curve.

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 The Money Market & the LM Curve
The Theory of Liquidity Preference – The Supply of Real Balances
The LM curve , the money market equilibrium curve

shows combinations of interest rates and levels of output such

that money demand equals money supply. (2 steps)

we explain why money demand we equate money demand

depends on interest rates and
income, emphasizing that because
people care about the purchasing
power of money, the demand for
money is a theory of real rather than
nominal demand.
with money supply—set by
the central bank—and find the
combinations of income and
interest rates that keep the
money market in equilibrium.

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 The Money Market & the LM Curve
The Theory of Liquidity Preference – The Supply of Real Balances

The theory of
liquidity
preference
If M stands for the
assumes there is a
supply of money
fixed supply of
and P stands for
To develop this real money
the price level,
theory, we begin balances.
then M/P is the
with the supply of
supply of real
real money
money balances.
balances.

( M/P ) s =
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 The Money Market & the LM Curve
The Theory of Liquidity Preference – The Supply of Real Balances
2 assumptions
The money supply M is an
exogenous policy variable chosen by
a central bank
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The price level P is also an
exogenous variable in this
model. (We take the price level
as given because the IS–LM
model—our ultimate goal in this
chapter—explains the short run
when the price level is fixed.)
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 The Money Market & the LM Curve
The Theory of Liquidity Preference – The Supply of Real Balances

• These assumptions imply that the supply of real money balances is

fixed and, in particular, does not depend on the interest rate.
• Thus, when we plot the supply of real money balances against the
interest rate, we obtain a vertical supply curve.

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 The Money Market & the LM Curve
The Theory of Liquidity Preference – The demand of Real Balances
The demand for money is a demand for
real money balances because people
hold money for what it will buy.

The higher the price level, the more nominal

balances a person has to hold to be able to
purchase a given quantity of goods.

If the price level doubles, an individual

has to hold twice as many nominal
balances in order to be able to buy the
same amount of goods.

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The Money Market & the LM Curve
The Theory of Liquidity Preference – The demand of Real Balances

The demand for money / The demand for real balances

depends on

the level of real income the interest rate

The cost of holding money

because individuals hold
money to pay for their (opportunity cost)
purchases, which, in turn, Interest forgone by holding money
depend on income. rather than other assets.

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 The Money Market & the LM Curve
The Theory of Liquidity Preference – The demand of Real Balances

the more costly the less cash will

The higher the
it is to hold be held at each
interest rate
money level of income

On these simple grounds, then, the demand for real balances increases with the
level of real income and decreases with the interest rate. The demand for real
balances, which we denote as L , is accordingly expressed:

L = kY – hi k, h, i > 0
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The Money Market & the LM Curve
The Theory of Liquidity Preference – The demand of Real Balances

L = kY – hi k, h, i > 0

k (+ve sign) h (-ve sign)

the sensitivity of the the sensitivity of the demand

demand for real balances to for real balances to the interest
the level of income rate

The higher the real income, The higher the interest rate,
the higher the demand for the lower the demand for
money money

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 The Money Market & the LM Curve
The Theory of Liquidity Preference – The demand of Real Balances

The demand function for real

balances, equation (6), implies that for
a given level of income, the quantity
demanded is a decreasing function of
the rate of interest.

For a given level of interest rate, The

higher the level of income, the larger
the demand for real balances and,
therefore, the farther to the right the
demand curve.

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 The Money Market & the LM Curve
The Theory of Liquidity Preference – equilibrium in the money market
How does the interest rate get to this equilibrium of money supply and money demand?
The adjustment occurs because whenever the money market is not in equilibrium, people try to adjust their
portfolios of assets and, in the process, alter the interest rate.
• If the interest rate is above the equilibrium
level, the quantity of real money balances
supplied exceeds the quantity demanded.
• Individuals holding the excess supply of
money try to convert some of their non-
interest-bearing money into interest-bearing
bank deposits or bonds.
• Banks and bond issuers, who prefer to pay
lower interest rates, respond to this excess
supply of money by lowering the interest
rates they offer.
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 The Money Market & the LM Curve
The Theory of Liquidity Preference – equilibrium in the money market
How does the interest rate get to this equilibrium of money supply and money demand?
The adjustment occurs because whenever the money market is not in equilibrium, people try to adjust their
portfolios of assets and, in the process, alter the interest rate.
• if the interest rate is below the equilibrium
level, so that the quantity of money
demanded exceeds the quantity supplied,
individuals try to obtain money by selling
bonds or making bank withdrawals.
• To attract now-scarcer funds, banks and
bond issuers respond by increasing the
interest rates they offer.

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 The Money Market & the LM Curve
The Theory of Liquidity Preference – equilibrium in the money market
How the interest rate responds to changes in the supply of money.

• Suppose, for instance, that the Fed suddenly decreases

the money supply. A fall in M reduces M/P, because P is
fixed in the model. The supply of real money balances
shifts to the left.
• The equilibrium interest rate rises from r to r , and the
1 2

higher interest rate makes people satisfied to hold the

smaller quantity of real money balances. The opposite
would occur if the Fed had suddenly increased the
money supply.
• Thus, according to the theory of liquidity preference, a
decrease in the money supply raises the interest rate, and
an increase in the money supply lowers the interest rate.
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We can now use the theory of Liquidity Preference to derive the LM curve.
We begin by considering the following question: how does a change in the economy’s level of
income Y affect the market for real money balances?

So, people Thus,

When engage in greater
income is more income
high, transactions implies
expenditure that require greater
is high, the use of money
money demand

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 The Money Market & the LM Curve
Income, Money Demand & the LM Curve

• Therefore, point E 1 is an equilibrium point in the money market. That point is recorded in
Figure 10-9 b as a point on the money market equilibrium schedule, or the LM curve.
• Consider next the effect of an increase in income to Y 2 . In Figure 10-9 a the higher level of
income causes the demand for real balances to be higher at each level of the interest rate,
so the demand curve for real balances shifts up and to the right, to L 2 .
• The interest rate increases to i 2 to maintain equilibrium in the money market at that higher
level of income. Accordingly, the new equilibrium point is E 2 .
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 The Money Market & the LM Curve
Income, Money Demand & the LM Curve

• In Figure 10-9 b we record point E 2 as a point of equilibrium in the money

market.
• Performing the same exercise for all income levels, we generate a series of
points that can be linked to give us the LM schedule.

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 The Money Market & the LM Curve
Income, Money Demand & the LM Curve

• In Figure 10-9 b we record point E 2 as a point of equilibrium in the money

market.
• Performing the same exercise for all income levels, we generate a series of
points that can be linked to give us the LM schedule.

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 The Money Market & the LM Curve
Income, Money Demand & the LM Curve

The slope of the LM Curve

Steeper Flatter

The greater the the lower the the greater the

The lower the
responsiveness of responsiveness of responsiveness
responsiveness of
the demand for the demand for of the demand
the demand for
money to income, as money to the for money to the
money to income,
measured by k interest rate, h , as measured by k interest rate, h ,

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 The Money Market & the LM Curve
Income, Money Demand & the LM Curve

• where a given change in income, Y , has a larger effect on the interest

rate, i , the larger is k and the smaller is h. If the demand for money is
relatively insensitive to the interest rate and thus h is close to zero, the
LM curve is nearly vertical.
• If the demand for money is very sensitive to the interest rate and thus h
is large, the LM curve is close to horizontal. In that case, a small change
in the interest rate must be accompanied by a large change in the level
of income in order to maintain money market equilibrium.

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 The Money Market & the LM Curve
How Monetary Policy Shifts the LM Curve

• Now we know that The LM curve tells us the interest rate that equilibrates the
money market at any level of income.
• Yet, as we saw earlier, the equilibrium interest rate also depends on the supply of
real money balances M/P.
• This means that the LM curve is drawn for a given supply of real money balances. If
real money balances change— for example, if the Fed alters the money supply—the
LM curve shifts.

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 The Money Market & the LM Curve
How Monetary Policy Shifts the LM Curve

The Position of the LM Curve

It follows that a change in the real money supply will shift the LM curve.

An increase in Money Supply shifts A decrease in Money Supply

the LM Curve to the right shifts the LM curve to the left

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The Money Market & the LM Curve
How Monetary Policy Shifts the LM Curve

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 The Money Market & the LM Curve
How Monetary Policy Shifts the LM Curve

the LM curve shows the

combinations of the interest
The LM curve is drawn for a
rate and the level of income
given supply of real money
that are consistent with
balances.
equilibrium in the market for
real money balances.
To
Summarize

Decreases in the supply of Increases in the supply of

real money balances shift real money balances shift
the LM curve upward. the LM curve downward.

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