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Session 8

The document discusses the supply of money, money market equilibrium, and the LM curve, explaining how the nominal money supply is controlled by the central bank and how real money balances are determined. It describes the relationship between interest rates and income levels, illustrating how shifts in income affect the demand for real money balances and the resulting equilibrium points on the LM curve. Additionally, it highlights the responsiveness of money demand to income and interest rates, and the conditions for simultaneous equilibrium in goods and money markets.

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ktprashant7
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42 views8 pages

Session 8

The document discusses the supply of money, money market equilibrium, and the LM curve, explaining how the nominal money supply is controlled by the central bank and how real money balances are determined. It describes the relationship between interest rates and income levels, illustrating how shifts in income affect the demand for real money balances and the resulting equilibrium points on the LM curve. Additionally, it highlights the responsiveness of money demand to income and interest rates, and the conditions for simultaneous equilibrium in goods and money markets.

Uploaded by

ktprashant7
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Session 8

1
The Supply of Money, Money Market Equilibrium, and
the LM Curve
• The nominal quantity of money supplied, M, is controlled by the central bank
M
• Real money supply is , where M and P are assumed fixed
P
• Figure shows combinations of i and Y such that the demand for real money balances
exactly matches the available supply

2
The Supply of Money, Money Market Equilibrium, and
the LM Curve
• Starting at Y1, the corresponding demand curve for real balances is L1 → shown in panel
(a)
• Point E1 is the equilibrium point in the money market
• Point E1 is recorded in panel (b) as a point on the money market equilibrium schedule, or
the LM curve
• (i1, Y1) pair is a point on LM curve

[Insert Figure 10-9 here]

3
The Supply of Money, Money Market Equilibrium, and
the LM Curve
• If income increases to Y2, real money balances increase to be higher at every level of i →
money demand shifts to L2
• The interest rate increases to i2 to maintain equilibrium in the money market
• The new equilibrium is at point E2
• Record E2 in panel (b) as another point on the LM curve
• Pair (i2, Y2) is higher up the given LM curve

[Insert Figure 10-9 here]

4
The Supply of Money, Money Market
Equilibrium, and the LM Curve
• The LM schedule shows all combinations of interest rates and levels
of income such that the demand for real balances is equal to the
supply → money market is in equilibrium
• LM curve is positively sloped:
➢ An increase in the interest rate reduces the demand for real balances
➢ To maintain the demand for real money balances equal to the fixed supply, the level of
income has to rise

Money market equilibrium implies that an increase in the interest


rate is accompanied by an increase in the level of income.

5
The Supply of Money, Money Market
Equilibrium, and the LM Curve
• The LM curve can be obtained directly by combining the demand
curve for real balances and the fixed supply of real balances
• For the money market to be in equilibrium, supply must equal demand:
M
= kY − hi
P
1 M
• Solving for i: i=  kY − 
h P

6
The Slope of the LM Curve
• The steeper the LM curve:
• The greater the responsiveness of the demand for money to income, as
measured by k
• The lower the responsiveness of the demand for money to the interest rate, h
→These points can be confirmed by experimenting with Figure or examining
equation: 1 M
i =  kY − 
h P

→A given change in income has a larger effect on i, the larger is k and the
smaller is h

7
Equilibrium and the Goods
and Money Market
• The IS and LM schedules summarize the [Insert Figure 10-11 here]
conditions that have to be satisfied for the
goods and money markets to the in
equilibrium
• How are they brought into simultaneous
equilibrium?
➢ Satisfied at point E in Figure,
corresponding to the pair (i0, Y0)
• Assumptions:
• Price level is constant
• Firms willing to supply whatever amount of
output is demanded at that price level

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