Topic2:- The L-M Curve

1/ Introduction
The L-M schedule sets out all of the possible combinations of real output, y
and the rate of interest, r consistent with equilibrium in the money market.
The money market will be in equilibrium if
M
D
= M
S
where M
D
is the Demand for Money
and M
S
is the Money Supply
n the fore!oin! analysis, we will be e"aminin! the demand and supply of real
balances.
i.e. M
D
#$ = M
S
#$
where $ is the price le%el
M
D
#$ id the demand for real balances
M
S
#$ is the real money supply
To make pro!ress, we will e"amine the determinants of real money demand
and real money supply.
2/ The Demand for Money
n !eneral, we can write that
M
D
#$ = !&y, r'
where y is income and r is the rate of interest.
This e"pression indicates that the demand for real money balances depends on
real income and the rate of interest. To e"amine this more closely, we follow
(eynes and partition money demand into ) components or moti%es for holdin!
money. *i+
Transactions moti%e
$recautionary moti%e
Speculati%e moti%e
A/ The Transactions Motive for Hodin! "ea #aances
Let the real money demand for transactions purposes be M
D
T
#$
M
D
T
is the amount of money carried around by an a!ent in a period in order to
undertake known transactions.
(eynes ar!ued that the demand for real transactions balances will depend on
the le%el of real income.
i.e. M
D
T
#$ = f&y'
,s real incomes rise, people will be able to afford to satisfy a !reater ran!e of
wants and needs and will plan to make a !reater le%el of known e"penditures
in a period.
Therefore - &M
D
T
#$'#-y . /
This e"pression says that, as real incomes rise, the demand for real balances
for transactions purposes will also rise.
#/ The $recautionary Motive for Hodin! "ea #aances
Let the real money demand for precautionary purposes be denoted by
M
D
$
#$
0here M
D
$
is the amount of money held by an indi%idual in a period in order
to cater for unforeseen or unpredictable transactions.
The demand for real balances for precautionary purposes will also depend on
the le%el of real income. Thus
M
D
$
#$ = !&y'
,s real incomes rise, the type and price of unforeseen or impulse purchases
will also increase. Thus,
- &M
D
$
#$'#-y . /
i.e. as real incomes rise, the demand for real precautionary balances will
likewise rise.
C/ The %pecuative Motive for Hodin! "ea #aances
Denote the money demand for speculati%e balances as
M
D
S
#$
t is this moti%e for holdin! money that links money demand to the rate of
interest. 1ecall that the classical economists re!arded the interest rate as bein!
determined in the capital market by
The flow of sa%in!s &supply of loanable funds'
The flow of in%estment &demand for loanable funds'
2lassicists %iewed that the rate of interest ad3usted quickly to balance sa%in!s
and in%estment.
(eynes re3ected this %iew by ar!uin! that the rate of interest was determined
in the money market
There are se%eral accounts#models which can be deployed to 3ustify a
relationship between M
D
S
and r. 0e will consider a simple account based on
the notion of the 4pportunity 2ost &42' of 5oldin! Money. There is a sli!htly
fuller account in Appendi& L-M
The opportunity cost of holdin! money can be re!arded as what is lost by not
holdin! your wealth in the form of interest bearin! assets. n simple
approaches, there are 6 ways of holdin! wealth
Money pays no interest
7onds pay a rate of interest per period
2learly, the 42 of holdin! money is the interest payments fore!one
8.7. 9ou can conceptualise money as notes, coins and +ero interest bearin!
bank accounts such as cheque accounts. The alternati%e to this would be to
hold interest bearin! accounts &deposit or sa%in!s accounts' or less liquid
assets such as bills, bonds shares etc:.
The ar!ument is simple. f interest rates rise, the 42 of holdin! money rises
and people will hold less money and more bonds. 0e can represent this insi!ht
!raphically in ;i!ure <. ,t a low rate of interest, r
<
the incenti%e to switch
from money into bonds is not !reat and people will tend to hold &demand'
more money, M
D
S<
. ,t a hi!h interest rate, r
/
,

the 42 of holdin! money is hi!h
and people will economise on money holdin!s &M
D
S/
'
'/ The %uppy of Money
The real money supply # supply of real balances is denoted by M
S
#$. ,s prices
rise the real money supply falls and %ice %ersa.
The money supply is taken to be e"o!enously determined and controlled by
the monetary authority # central bank. Thus, the money supply does not depend
on either r or y and is a policy instrument which can be chan!ed at the behest
of the authorities.
(/ )*uii+rium in the Money Mar,et
0e can take our e"pressions for transactions, precautionary, speculati%e
balances and the money supply and set them out in ;i!ure 6 . 5ere, r
e
is the
rate of interest# price of bonds at which a!ents in the economy willin!ly hold
the issued real money stock.
M
D
S<
#$ M
D
S/
#$
M
D
%
/$
r
<
r
/
-i!ure 1- %pecuative Demand for Money
Chan!es in the Money %uppy
Suppose the 2entral 7ank decided to increase the money supply from M
S
/
to
M
S
<
. This would cause the money supply line to shift out as seen in ;i!ure ).
The money supply schedule shifts but the money demand cur%e is unaffected
because income, which determines transactions and precautionary holdin!s
has not chan!ed.
;ollowin! the increase in the money stock, money holdin!s are !reater than
those required to finance known and precautionary transactions. ,!ents will
r
M
D
/$
r
e
-i!ure 2- )*uii+rium in the Money Mar,et
M
S
#$
M
D
#$
M
D
S
#$
M
D
T
#$ =
M
D
$
#$
M
D
#$ = M
S
#$
M
D
/$
. M
%
/$
M
S
<
#$ M
S
/
#$
r
e
/
r
e
<
-i!ure ' / Increase in the Money %uppy
r
attempt to purchase bonds dri%in! up their price and down the rate of interest
from r
e
/
to r
e
<
. The price of bonds will rise# rate of interest fall until the
increased money stock is willin!ly held.
Thus, chan!es in r, the rate of interest, are the mechanism which re-equilibriate
the money market. There is no a priori reason why r should also ser%e to
equate sa%in!s and in%estment as the classical school belie%es.
0/ Derivin! the L-M %chedue
The L-M cur%e is defined as all %alues of r and y consistent with equilibrium
in the money market. This su!!ests that to deri%e the L-M schedule we should
%ary y and establish what happens to r in order to restore money market
equilibrium.
f y increases, both the transactions and speculati%e demand for money will
increase out of a fi"ed real money stock. This will require a!ents to sell bonds
in order to finance hi!her known and precautionary purchases. f there is
increased sellin! pressure on the fi"ed stock of bonds, then the price of bonds
will fall &i.e. the interest rate will rise'. This is set out in ;i!ure >a for the case
when income rises from y
/
to y
<
to y
6
and where we assume a linear money
demand cur%e
0e obtain the L-M cur%e by mappin! r %ersus y. ,s real income
increases the transactions and precautionary demand for real balances
increases out of a fi"ed real money stock. This necessitates bond sales
r
M
D
/$
-i!ure (a / Derivin! the L-M Curve
M
D
#$ &y=y
6
'
M
S
#$
M
D
#$ &y=y
<
'
M
D
#$ &y=y
/
'
which dri%e down the price of bonds# up the rate of interest in order to
restore equilibrium in the money market.
1/ 2hat Determines the %ope of the L-M %chedue
The slope of the L-M cur%e depends on
<. the interest sensiti%ity# elasticity of the speculati%e demand for money
6. the income elasticity of money demand
9ou should attempt to construct L-M schedules for different interest and
income elasticities
3/ 2hat causes the L-M %chedue to %hift
The L-M cur%e is sets out all the combinations of r and y consistent with
equilibrium in the money market. ?quilibrium in the money market results
when M
D
#$ = M
S
#$. The L-M cur%e is deri%ed by %aryin! real income !i%en a
fi"ed real money stock and e"aminin! the chan!es in r required to maintain
money market equilibrium. f the real money stock chan!es, then a new L-M
cur%e will be en!endered.
The real money stock is the nominal money supply deflated by some measure
of the price le%el. Thus@-
r
y
-i!ure (+ / Derivin! the L-M Curve
y
/
y
<
y
6
r
/
r
<
r
6
L-M
<. , rise in the real money stock results when either the nominal money
supply rises or the price le%el falls.
6. , fall in the real money supply results when either the nominal money
supply falls or the price le%el rises.
2onsider a rise in the real money supply from &M
S
#$' to &M
S
#$'A.
,t the ori!inal le%el of the money stock, MS#$, the equilibrium rate of interest
when y = y
/
is r
/
. ,s income increases to y
<
, the money demand schedule shifts
up to M
D
#$&y
<
'. The hi!her money demand from a fi"ed money stock causes
a!ents to sell bonds to obtain money for increased transactions and
precautionary purposes. This causes the interest rate to rise until the money
market returns to equilibrium at the hi!her interest rate, r
<
. Mappin! r %ersus y
we obtain L-M.
0hen income is y
/
, an increase in the money stock from &M
S
#$' to &M
S
#$'A
causes an e"cess supply of money for transactions and precautionary purposes.
,!ents attempt to purchase bonds, increasin! the demand for bonds from a
fi"ed supply. This dri%es up bond prices and down interest rates from r
/
to r
/
A
until the e"panded money supply is willin!ly held.
M
D
#$&y
/
'
M
D
#$&y
<
'
y
/
y
<
r
/
A
r
/
r
<
A
r
<
&M
S
#$' &M
S
#$'A
r
rea M
D
. M
s
r
y
L-M4
L-M
-i!ure 0: An Increase in the Money %toc,
causes the L-M Curve to %hift 5ut6ards7
f income rises from y
/
to y
<
and the money supply is at the hi!her le%el
&M
S
#$'A, there is an increased demand for money for transactions and
precautionary purposes. ,!ents attempt to sell bonds dri%in! down the bond
price and pushin! up the rate of interest from r
/
A to r
<
A. The L-M schedule for
the e"panded money stock is L-MA.
Thus, at any le%el of income, lower interest rates are necessary to equilibriate
the money market !i%en a rise in the money supply. The hi!her money stock
results in e"cess balances for transactions and precautionary purposes which
a!ents use to attempt to increase purchases of bonds. This dri%es up bond
prices and down the rate of interest. Therefore at any le%el of income, interest
rates must fall to restore money market equilibrium. 5ence, a rise in the real
money stock causes the L-M schedule to shift outwards.
Learnin! 5+8ectives
5n readin! this and the accompanyin! Appendi& L-M9 you shoud +e a+e
to:-
17 :nderstand the Money Mar,et7 2hat are the determinants of Money
Demand7 2hy is the specuative demand for money thus named7 Ho6
does the money mar,et return to e*uii+rium foo6in! a shoc, to
either money demand or money suppy
27 Derive the L-M schedue
'7 :nderstand the factors 6hich determine the sope of the L-M curve
>. :nderstand 6hat causes the L-M curve to ;shift< =i7e7 6hat factors are
hed constant 6hen derivin! the L-M curve>
Jim Stevens
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