802 The LM Model

MCXmoney-confessions-1108-1-medium-newHere’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:

  • Understand what are real balances/real money demand/supply
  • Understand why the supply curve is a vertical line
  • Identify the events occuring when money supply increases or decreases
  • Derive the LM curve
  • Shift the LM curve accordingly when real money supply decrease/increase, prices decrease/increase

 

 

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7 Comments

  1. Martyn says:

    In the UK the bank of england sets the short run interest rate. how does a reduction in the rate of interest cause the LM curve to shift or what changes would this have on the IS/LM/AS/AD curve?

    • Quickienomics says:

      Hi Martyn, the central bank affects the interest rate by adjusting the money supply in the economy through open market operations, thus resulting in a shift of the LM curve. Hope that helps. 🙂

  2. Ian says:

    Hey man, quick question. how do you derive the use of deposit multiplier in increasing money supply if i.e if the public transfers their cash into banks based on (M= PC +R(1/a)). I’ve been looking through the notes and can’t find the link between the two. = thanks in advance!

    • Quickienomics says:

      Hi, When people deposit their money into the banks, the banks can lend more money out, thus increasing the money supply in the economy. This is seen as an increase in R in your equation and when multiplied by a multiplier, M starts to increase. But there is an important assumption to be made here. The important assumption is that the banks have already fulfilled their reserve ratio requirements. The reason for this assumption is that if they haven’t fulfilled the requirements, they wont be able to lend the additional deposits out.

  3. Siddharth says:

    Hey! I was just wondering, at around 5:40, the point B in the right hand diagram corresponds to the point C in the left hand diagram, am i right? And the point below B in the right hand diagram, to the right of A, corresponds to B in the LH diagram (point of excess demand)?

  4. Rachel says:

    Hello you wonderful people!
    You have given me hope that I may get at least some marks in this subject. I have a bit of a basic question:
    Is C1 always less than 1? I know MPS + MPC = 1, but can they be negative?
    Thanks and keep up the good work!
    Rachel

    • Quickienomics says:

      Hello Rachel,

      I’m afraid that they cannot be negative. And C1, technically, does not always have to be less than 1. Some people spend all that they have and do not save!