ECON 9/25 Ch. 6 Money Supply and LM Curve

Two Important Aspects of Chapter 5:
- Consumption isn't a function of interest rates, it is a function of income. As income increases, so will consumption.
- Switching from self-regulating economy to a gov't regulated economy

Chapter 6:
- Money isn't only held to buy things, there are other reason to hold money

Interest Rates and Aggregate Demand:
- Interest rates can affect a number of components of aggregate demand
- Business direct investment
- Housing construction (high short term rates raise the cost of construction, high mortgage rates decrease the demand for housing)

Wealth Allocation & Money:
- Non-interest earning and interest earning holdings
- Wh = B + M
- Wh = wealth (assets)
- B = Bond holdings (all non-money assets)
- M = money holdings
- Money is considered money held that isn't earning interest
- Money put into stocks is "speculating or speculative"
- When you make an investment you're buying into the status quo (what is happening right now, locking you into the current rates)
- Bonds have a primary and secondary market (when primary interest rates go up, bonds in the secondary market will go down)
- Interest rates and money demand are related

The Value of Holding Money:
- Although holding money doesn't earn interest, it allows the consumer freedom to pick when to invest in bonds (when the critical interest rate is right)

The Liquidity Trap:
- Generally, as interest rates fall, people move away from bonds into money holdings
- However, at very low rates of interest all increments to wealth will be held as money and further drops in the interest rate will not increase money holdings
- This situation is called the liquidity trap

The Total Demand for Money:
- Directly related to income and inversely related to interest rates
- The total demand for money is the sum of the transactions, precautionary, and speculative money

Demand for Money Equation:
- Md = co + c1Y 0 c2r
- co = autonomous money demand
- c1Y = transactions and precautionary demand (c1 > 0)
- c2r = speculative demand (c2 > 0)
- Similar to Cambridge model is you ignore "-c2r"

The Supply of Money:
- Controlled by the central bank (FED)
- Increases money supply by purchasing gov't bonds and decreases money supply by selling gov't bonds

Figure 6-6 (Equilibrium in Financial Markets (LM Curve))
- Ms0 is vertical money supply completely controlled by FED (unlike reality)
- When incomes rise, consumption increase and speculative money goes down, causing interest rates to rise
- Interest rate is a linear function of income in financial markets
- Ms = co + c1Y - c2r
- r = (co + Ms)/c2 + (c1/c2)Y (LM Curve)

Money Supply: The Policy Variable in Financial Markets
- Ms is the intercept of the LM Curve
- LM Curve shows how Ms affects the equilibrium relationship between income and interest rates in financial markets
- An increase in the money supply shifts the LM Curve down and to the right. A decrease shifts the LM Curve up and to the left
- Keynes says the LM Curve can be used to find out information, plot it, and use it to make decisions about how the economy will perform
- Not only should the government be involved, but this proves that they mechanically can be involved

The Slope of the LM Curve:
- Classical - c2 is 0 (vertical LM Curve)
- Keynes - c2 is high (more horizontal LM Curve)
- Liquidity trap has c2 of infinity (causing horizontal LM Curve)

LM Summary:
- Shows the equilibrium combinations of income and interest rates in financial markets
- Slopes up and to the right (direct relationship)
- Flat (steep) when interest elasticity of money demand is high (low)
- Shifts down (up) and to the right (left) with an increase (decrease) in money supply
- Shifts up (down) and to the left (right) when money demand increases (decreases) at given levels of income and interest rates