L3 LM

Question 1

What happens when the money market, with Ms/P and L(i,Y) adjusts to equilibrium?

Answer 1

Equilibrium determined by people making portfolio decisions

Whenever it isn’t, people adjust their assets and portfolios accordingly. If i is above, quantity supplied exceeds that demanded, so those holding excess supply try to get in on this interest rate opportunity and convert their non-interest bearing money into interest-bearing deposits

Question 2

What does the CB do for LM?

Answer 2

It uses the money supply to control nominal interest rates. For example it can inject money into the economy (shift M/P), which will mean the current nominal interest rate is now too high. People having all this cash decide to put it into bonds, driving this price up and therefore reducing the nominal interest rate

Question 3

What is the relationship between the fixed future return from a bond (d), the current price of the bond (q), and the nominal interest rate?

i + 1 = d/q

Answer 3

i + 1 = d/q

Question 4

What happens in the money market when income rises?

Answer 4

Higher Y -> more demand for real money due to the transactions motive

Desire to sell bonds drives down their price

This increases the nominal interest rate until the opportunity cost of holding M/P high enough for equilibrium; i keeps on rising until we feel like we’re forgoing the chance to hold bonds

This gives us a positive relationship between i and Y, which is the LM curve

Question 5

What shifts the LM curve?

Answer 5

Anything that changes the equilibrium interest rate holding Y constant, that is:

Changes in M
Changes in P
Exogenous changes in liquidity demand

Question 6

What determines slope of LM curve?

Answer 6

1. Interest elasticity of money demand

How much must i rise to contract money demand? Movement along

2. Income elasticity of money demand

What is the horizontal shift in money demand for a given interest rate? The more income elastic D is, the more i changes. Bigger rise in money demand as Y risks so need a bigger rise in i to clear market

(Imagine there was a shift in money demand)

Question 7

Difference between sticky prices and sticky inflation?

Answer 7

Sticky prices are INSTANTANEOUS effects of policy changes, so prices are fixed and output adjusts immediately

Sticky inflation expectations relate to price growth over short run horizon; just because prices are fixed at the time of analysing the policy doesn’t mean they’ll remain the same in 6 months

Question 8

What happens to inflation when we are thinking through effects of rises in Y?

Answer 8

We see that i rises and therefore r rises, as we assume inflation is fixed