Money Demand

Money demand (demand for real balances) is influenced : • positively by income

Money Demand

Money demand (demand for real balances) is influenced : • positively by income•negatively by interest rates.

Money Demand

Money demand (demand for real balances) is influenced : • positively by income•negatively by interest rates.

•That is: + - md = f ( y , i)

Money Demand: inverse relation between interest rate and real balances

m1d

Real balances

r

Money Demand: inverse relation between interest rate and real balances

m1d

Real balances

r

Equilibrium in the money market

m1d

M1s (P1)

Real balances

r

r1

Increase in Demand for Money

m1d

M1s (P1)

Real balances

r2

m2d

r1

LM Curve

m1d

M1s (P1)

Real balances

r

income

m2d

LM Curve

m1d

M1s (P1)

Real balances

r

income

r1

r2

LM Curve

m1d

M1s (P1)

Real balances

r

income

r1

m2d

r2

LM1(P1)

LM Curve

m1d

M1s (P1)

Real balances

r

income

r1

m2d

r2

LM1(P1)

LM Curve: expansionary monetary policy

m1d

M1s (P1)

Real balances

r

income

r1

m2d

r2

LM1(P1)

LM Curve: expansionary monetary policy

m1d

M1s (P1)

Real balances

r

income

r1

m2d

r2

LM1(P1)M1s (P2 )

LM Curve: expansionary monetary policy

m1d

M1s (P1)

Real balances

r

income

r1

m2d

r2

LM1(P1)M1s (P2 )

LM Curve: expansionary monetary policy

m1d

M1s (P1)

Real balances

r

income

r1

m2d

r2

LM1(P1)M1s (P2 )

AD in a Keynesian System

m1d

M1s (P1)

Real balances

r

income

r1

m2d

r2

LM1(P1)M1s (P2 )

LM2(P2)

Prices and the LM

Prices can change the position of LM the same way changes in the stock of money supply would. A decrease in price level is exactly the same as an increase in the money supply. Both will shift the LM curve to the right. An expansionary monetary policy.

AD in a Keynesian System

ADReal income

Real income

LM (P1)LM (P2)

IS

r1

r2

P1

P2

y1 y2

a

b

a’b’

AD in a Keynesian System

ADReal income

Real income

LM (P1)LM (P2)

IS

r1

r2

P1

P2

y1 y2

a

b

a’b’

IS’

AD’

G or I or X

Vertical LM

If money demand is completely independent of the interest rates, then it will be vertical and LM will be vertical. In this case, fiscal policy in completely ineffective.

Vertical LM

If money demand is completely independent of the interest rates, then it will be vertical and LM will be vertical. In this case, fiscal policy in completely ineffective. This is the case of complete crowding out.

Vertical LMIf money demand is completely independent of the interest rates, then it

will be vertical and Lm will be vertical. In this case, fiscal policy in

completely ineffective. In this case fiscal policy does not have any effect on the AD. Only monetary policy would be effective

Vertical LM

IS

IS’’IS’

LM

Expansionary Monetary Policy and AD in a Keynesian System

ADReal income

Real income

LM (P1)LM (P2)

IS

r1

r2

P1

P2

y1 y2

a

b

a’b’

LM (M 2 P1)

LM (M2 P1)

AD’

Expansionary Monetary Policy and AD in a Keynesian System (Vertical LM)

Unlike Fiscal Policymonetary policy is very potent

IS

lm1

lm2

Lm1’Lm2’

AD’AD

P1

P2

r1

r2

Keynesian AS

N

W

N1 N2L1

d

Keynesian AS

f(N)

N

W

y

N

N1 N2

Keynesian AS

f(N)

N

W

y

N

N1 N2

Keynesian AS

f(N)

N

W

y

N

45y

y

P

yN1 N2

P1

y1

AS

Keynesian AS

f(N)

N

W

y

N

45y

y

P

yN1 N2

P1

y1

AS

Keynesian AS

f(N)

N

W

y

N

45y

y

P

yN1 N2

P2

P1

y1 y2

Keynesian AS

f(N)

N

W

y

N

45y

y

P

yN1 N2

P2

P1

y1 y2

AS

Keynesian AS: Technological advance

f(N)

N

W

y

N

45

y

y

P

yN1 N2

P2

P1

y1 y2

AS AS’