L18 - Money, Interest and GDP: The LM Curve Flashcards
What are the only two assets in the model economy?
Just two assets: Bonds & Money
- Bonds: Have interest due to it being risky
- Money: Not risky so no interest
Focus just on the money market. Assume supply fixed (controlled by BoE). Even though, BoE control monetary base (M0). Very small (less than 5%)
What are the two aspects of liquidity?
-Uncertainty about how much money can be obtained
by selling it and
-How easy it is to make a sale
What is a bond?
A document that promises to pay stated sum of money as interest each year.
And repay face value of bond (principle) at the redemption date (term to maturity)
What is the Present Value (PV)?
Refers to value of future payment/payments which ownership of asset gives claim.
Present value of any asset that yields a given stream of money over time is negatively related to the current market interest rate.
For example, a bond that promises to pay £ 100 one year hence:
When the interest rate is 5 per cent, the present value
is £ 95.24.
PV = 100/1.05
= 95.238
= 95.24
Why is Present Value important?
Establishes market price for an asset.
What are the 2 main assumptions behind the LM curve?
- Interest inverse to Price
i. e: If interest rises, price of asset falls. If interest falls, price of asset rises
-The nearer the maturity date of a bond, the less the
bond’s, value will change with a change in the
market rate of interest.
What is the demand for money?
The amount of wealth that everyone in the economy wishes to hold in the form of money balances is called the demand for money.
What are the three motives for holding money?
- Transactionary Demand for money
- Precautionary Demand for money
- Speculative Demand for money
What is the calculation for liquidity?
L= L1 + L2
L1: Transactionary and Precautionary Demand for
money
L2: Speculative Demand for money
What is the Transactionary Demand for money?
Transactionary balances are held to pay for the goods and services produced by firms and workers.
i.e: Money held to pay certain things
What is the Precautionary Demand for money?
Precautionary balances are held to cushion against uncertainties about the timing of cash flows
i.e. Mortgage Payments
What is the Speculative Demand for money?
Money held in speculation of interest rate changes.
i.e Money held if interest rate of assets falls
The classical view sees no speculative demand.
What does the demand for money depend on?
- Prices
- Output
What is the LM curve?
Shows all of the combinations of income and interest
rate for which the real demand for money equals the real supply
- Shows aggregate of money market equilibrium
Why is the LM curve positively sloped?
Because a rise in income increases the quantity of money demanded
(transactions and precautionary demand) and so must be accompanied
by a rise in the interest rate that decreases the quantity of money
demanded
(speculative demand) by the same amount if equilibrium is to be
maintained with total quantity demanded equal to the total supply.
