The LM Curve. r LM. r 2. r 1. M d /P, M s /P

Transcription

1 The LM Cuve Recall what chaacteized movements along the IS cuve: When changed saving would shift along a stable investment schedule, tacing out all of the pais of and that yield equilibium in the goods maket. Now we shall do the vey same thing with the asset maket. When changes, the demand fo money shifts along a stable money supply schedule tacing out all of the and pais that give equilibium in the maket fo money. This schedule which is taced out in the, plane is called the LM cuve, denoting money demand money supply equilibium. LM 2 1 MD( 2 ) MD( 1 ) 1 Why ae money demand cuves downwad sloping? t highe levels of inteest wealth holdes will choose to hold moe nonmonetay assets elative to money, so the quantity of money demanded deceases as the inteest ate ises. This is a movement along the money demand schedule. When output ises agents engage in moe tansactions. This shifts the eal money demand schedule fo evey inteest ate. t the old inteest ate, 1, the quantity of money demanded exceeds the eal supply of money. Recall that the pice of nonmonetay assets and thei eal etuns ae negatively elated. s people demand moe money at the initial inteest ate the pice of nonmonetay assets is bid down. Wealth holdes selling thei nonmonetay assets will dive the pice down.. s the pice falls the eal inteest ate on these assets ises. s the inteest ate begins to ise ( a movement along the new money demand schedule) the quantity of money demanded by the public falls. This pocess continues until M s = M d.

2 Factos that Shift the LM Cuve: ll of these, except the fist, will be vey familia! They ae the same ones that we discussed when we talked about the factos that affected money demand. ewae though when we conside a ise in the pice level. n incease in the pice level with espect to a fixed level of money supply will cause the eal money supply to fall. ut, this does not affect the eal money demand (Chapte 7 ddendum), it does affect nominal money demand, though. 1. Nominal money supply inceases: 2. Pice level ises: Ms P = L, + πe eal money supply shifts down P Ms = L, + πe eal money supply shifts to the left along a stable money demand function 2 1 LM MD 3. Expected inflation ises: Recall ou answe which we gave in Chapte 7

3 Highe etun on nonmonetay assets elative to money. People choose to hold fewe dollas than they did befoe. π e M d = P L (, + π e ) Md P = L, + πe eal money demand shifts down fo any level of output the decease in eal money demand deceases the eal inteest ate that cleas the asset maket. LM ( 1 ) Let s descibe the adjustment stoy: fte the initial decease in money demand,

4 the eal quantity of money demanded at 1, ( 1 ), exceeds the available supply denoted by. Thus, 1 is no longe the maket cleaing ate of inteest. How does the inteest ate adjust? Wealth holdes want less money in thei potfolios, theefoe they will poceed to exchange money fo nonmonetay assets. s wealth holdes ente the maket fo nonmonetay assets, gobbling up bonds, land etc. they will dive the pice of these nonmonetay assets up! Now, what is the elationship between the pice of an asset and its eal inteest ate? s the pice of the asset ises, its yield o ate of etun will fall. The ate of etun is the eal inteest ate. s the eal inteest ate falls, nonmonetay assets become less and less desiable. Finally, wealth holdes ae satisfied with thei potfolios when the inteest ate eaches 2. Note that ou stoy of wealth holdes swapping nonmonetay assets fo money occus as movements along. Note what happens to the LM cuve when money demand falls. The initial cuve passes though point, whee the output is and the ate of inteest is 1. fte the fall in money demand, with output fixed at, the maket cleaing ate of inteest falls to 2. Thus the new LM cuve passes though point which coesponds to in the money demand money supply gaph. The new LM cuve is lowe because the eal ate of inteest that cleas the asset maket is lowe fo evey level of output. 4. Nominal inteest ate on money ises: Recall Chapte 7 highe etun to holding money will mean, ceteis paibus, people will choose to hold moe money in thei potfolios. i m M d = P L (, + π e, i m ) Md P = L, + πe, i m eal money demand shifts upwad

5 LM ( 1 ) M d /P, M s /P We can follow the discussion in the book on p The incease in the nominal etun to money means that people will choose to hold moe money in thei potfolios at the same level of output and the same eal inteest ate. t the initial inteest ate 1 the eal quantity of money demanded, ( 1 ), exceeds the available supply,, So 1 no longe cleas the asset maket. What is the pocess by which the asset maket cleas? The inteest ate will be bid up. Now that agents wish to hold moe money in thei potfolios than they did befoe the change in the exogenous fact, agent swill sell nonmonetay assets. This will dive down the pice of the nonmonetay assets. This will incease the eal inteest ate that these assets pay. s the eal inteest ate ises(this is now a movement along the new money demand function ) the attactiveness of holding money falls. This pocess continues until wealth holdes desied level of money demanded equals the available supply. This whole pocess epesents a movement fom to. The incease in money demand with output at, the maket cleaing level of inteest ises to 2. The new LM cuve must pass though point because this epesents equilibium in the asset maket. The new LM cuve is highe because the maket cleaing eal ate of inteest is highe fo eve level of output.

6 5. Wealth inceases: Recall chapte 7 n incease in wealth means that pat of this incease will be held in the fom of money wealth M d = P L(, +π e, wealth) Md P = L, + πe, wealth eal money demand shifts upwad LM MD M d 2 ( 1 ) /P, M s /P 6. Risk of nonmonetay assets inceases: People will choose to hold moe money than they did befoe in thei potfolios. isk M d = P L (, + π e ), isk of altenative assets Md P = L, + πe, isk of altenative assets eal money demand shifts upwad

7 LM ( 1 ) M d /P, M s /P 7. Risk of money inceases: People will choose to hold fewe dollas in thei potfolios than they did befoe. isk M d = P L (, + π e, isk of money) Md P = L, + πe, isk of money eal money demand shifts down LM ( 1 )

8 8. Payments technology inceases: People need not hold as much money as they did befoe. Money demand will fall. efficiency of payments technologies ( ) M d = P L, + π e, efficiency of payments technologies eal money demand shifts down LM ( 1 ) 9. Nonmonetay asset liquidity ises: The degee to which one can exchange nonmonetay assets fo goods, sevices and othe assets, has isen theefoe, people will choose to hold less cuency and moe nonmonetay assets. liquidity of altenative assets ( ) M d = P L,+π e, liquidity of altenative assets eal money demand shifts down

9 LM ( 1 ) good execise fo you would be to compae the numeous vaiables that affect the demand fo money (which ae detailed in the handout titled Chapte 7 ddendum) with the factos that shift the LM cuve.