1. The Goods Market and the IS Curve
How fiscal policy shifts the IS Curve:
In summary:
Expansionary Fiscal Policy (increase in Government Purchases or decrease in taxes) will shift the IS Curve to the right
Contractionary Fiscal Policy (decrease in Government Purchases or increase in taxes) will shift the IS Curve to the left
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

2. The Money Market and the LM Curve
Summary so far:
We are using the IS-LM model to derive the aggregate demand curve to study economic fluctuations in the economy in the short run
IS-LM model is an interpretation of John Maynard Keyne’s theory on aggregate demand
We have derived the IS Curve using the Keynesian Cross and the Investment Function
Now we need to derive the LM Curve
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

3. The Money Market and the LM Curve
The LM Curve plots the relationship between the interest rate and the level of income that arises in the money market
We use the Theory of Liquidity Preference to derive the LM Curve
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

4. The Money Market and the LM Curve
Theory of Liquidity Preference:
Keynes’s theory: the interest rate adjusts to balance the supply and demand of money in the short run
Begin with the supply of real money balances
M = supply of money
P = price level
(M/P)s = supply of real money balance
Note: real money balance means the quantity of money expressed in terms of the quantity of goods and services it can buy
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

5. The Money Market and the LM Curve
Theory of Liquidity Preference:
This theory assumes that the supply of real money balances is fixed
Therefore:
(M/P)s = M/P
M (Money supply) is fixed because it is chosen by the central bank – it’s an exogenous variable
P (price level) is fixed because this is a model of the short run and prices are sticky or fixed in the short run
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

6. The Money Market and the LM Curve
Theory of Liquidity Preference:
Therefore, the supply of real money balances is fixed and does not depend on the interest rate
In a graph, the supply of real money balances is a vertical line
See graph (next slide)
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

7. The Money Market and the LM Curve
Interest rate, r
Supply
M/P
Real Money Balances, M/P
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

8. The Money Market and the LM Curve
Theory of Liquidity Preference:
Next consider the demand for real money balances
The interest rate is one determinant of how much money (cash) people to choose to hold
Interest rate is the opportunity cost of holding money (cash in your pocket)
Because if you weren’t holding money as cash you would put it in a bank deposit account that would earn interest
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

9. The Money Market and the LM Curve
Theory of Liquidity Preference
Demand for real money balances: when the interest rate rises people want to hold less money (cash) (thus demand less cash) and instead invest it in a bank etc. to earn the high interest rate
Therefore:
(M/P)d = L(r)
The demand for real money balances is a function of interest rates
(Note: L stands for liquidity but just means a ‘function of’)
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

10. The Money Market and the LM Curve
Theory of Liquidity Preference:
In a graph the demand for real money balances is downward sloping because it depends negatively on the interest rate
See graph on next slide (curve drawn during lecture)
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

11. The Money Market and the LM Curve
Interest rate, r
M/P
Real Money Balances, M/P
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

12. The Money Market and the LM Curve
Theory of Liquidity Preference
The combination of the supply and demand for real money balances shows the equilibrium interest rate
According to the theory of liquidity preference, the interest rate adjusts to equilibriate the money market
See graph on next slide
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

13. Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

14. The Money Market and the LM Curve
Theory of Liquidity Preference
Why does the interest rate adjust to equilibriate the money market?
For example, if the interest rate is above the equilibrium level, quantity of real money supplied exceeds the quantity demanded
People holding the excess supply of money want to earn the high interest rate and deposit it in a bank account
Banks respond to this by lowering their interest rates (they prefer to pay lower interest rates on the deposit accounts)
And the interest falls until equilibrium is reached
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

15. The Money Market and the LM Curve
Theory of Liquidity Preference:
Now, suppose the central bank decreases the money supply
(M/P)s: M falls and P is fixed in the model
Therefore (M/P)s falls and the supply of real money balances line shifts to the left and the interest rate rises from r1 to r2
See graph on next slide
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

16. Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

17. The Money Market and the LM Curve
Using this theory of liquidity preference, we can now drive the LM Curve
The LM Curve plots the relationship between interest rates and income that arises in the money market
So we need to see how income affects the money market
A change in income will affect the demand for real money (recall this from chapter on Money and Inflation)
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

18. The Money Market and the LM Curve
Deriving the LM Curve:
When income is high, expenditure is high, so people engage in more transactions that requires the use of money (cash)
The greater income, the greater the money demand
Therefore, money demand function can be written as:
(M/P)d = L(r, Y)
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

19. The Money Market and the LM Curve
Deriving the LM Curve:
The quantity of real money demand is negatively related to interest rates and positively related to income
If there is an increase in income, this will cause the money demand curve to shift upwards or to the right (it’s a shift of the curve because income is not on either axis (interest rates and real money balances are on the axes)).
This shift of the demand curve then will result in an increase in the interest rates
See graph (a) on next slide
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

20. Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

21. The Money Market and the LM Curve
Deriving the LM Curve:
Therefore, according to the Theory of Liquidity Preference, an increase in income results in a higher demand for real money and thus leads to a higher interest rate
The LM curve summarises this relationship
We start off at income Y1. At this income level real money demand equates with real money supply at interest rate r1
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

22. The Money Market and the LM Curve
Deriving the LM Curve:
At income Y1, interest rate is r1
Plot this as one point showing the relationship between interest rates and income in the money market
Then, income rises to Y2, this causes an increase in money demand, so money demand curve shifts to the right and this leads to a higher interest rate, r2
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

23. The Money Market and the LM Curve
Deriving the LM Curve:
At income Y2, interest rate is r2
Plot this as another point showing the relationship between interest rates and income in the money market
Join the dots and you get an upward sloping LM curve
See graph (b) on previous slide with graphs
Source: "Macroeconomics", Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10