Here’s the second half to the ISLM model and after mastering how the LM model works, you are ready to combine the IS and LM to analyze macroeconomic theory. Seems like macroecons isn’t so tough eh? I hope you enjoy what you’re studying to this point. Read the newspapers and I bet you have a better understanding of what is going on in this chaotic world.
In the liquid assets market, we’re talking about money. Yeap, everybody’s favorite topic! You have to like learning about the LM model because it’s money! So how much money are you holding right now? And I mean in your wallet, piggy bank, Kong Guan biscuit tin, under the bed, ANYWHERE besides a bank. Do you have a habit of always making sure you have a certain amount of cash in your hands? Yes! Now that’s your demand for money. So where’s the money that you DON’T demand? It’s obviously in the banks!
Therefore, when we talk about the demand for money, we’re refering to how much money you would love to hold in your hands! Think about this: let’s say we live in a world where banks offer interest rates that are at least 1 to 2%. That’s like 10 times or more higher than what the real world is offering: like what o.stupid%? Now I’m talking about the type of deposits that are totally liquid, which means you can take your money out of the bank’s vault any time by going to the ATM. I’m not talking about fixed deposits or any investments of that kind.
So if the banks announce that they would now pay you 5% more on your money that is placed in the bank, would you rush down to deposit your cash from your wallet or biscuit tin? I bet you would! $100 would become $105 in a year and based on compounding interest, we would get even more!
So let’s say you happily put your money in the bank and a year later, the banks announces that they have to cut their interest rates to just 1%! Would you want to take your money out of the banks immediately? Say yes. Why? Because in our intro to econs world, there are things called bonds which we can buy and sell when it appreciates in value. We have no idea what the returns might be but hey, it beats earning just a pathetic 1% from the banks right? So you withdraw your money out, leaving some for emergency purposes, and put your money into bonds.
As we can see from this scenario, the demand for money, just like any other demand curve, would be downward sloping if we plotted it on a graph with interest on the vertical axis and quantity of money in the horizontal axis.
But the bank can’t just determine interest rates whenever they like it! How do they decide on their interest rates? Just like how equilibrium price is determined by demand and supply of a good, interest rates are determined by the demand and supply of money!
Therefore, when we find all these points of equilibrium in the liquid assets market, we can then derive the LM function, which is a map of all the equilibirum points. Then we use this LM function together with the IS model to analyze macroeconomic disturbances. Getting the big picture?
At the end of this video, you should be able to:
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