The Asset Market & LM Curve

Question 1

Flow & Stock Variables

Answer 1

A flow variable is measured over a period of time e.g income, consumption

A stock variable is measured at one point in time e.g the money, number of workers

Question 2

Keynsian Money Demand Function

Answer 2

L = K * Y - H * i

L = Liquidity (real demand for money)

K * Y = Transaction component, demand for money for the purpose of buying G/S
- Varies with real income, K is the sensitivity of money demanded to a change in income, also known as the elasticity of money demand, typically is 1

H * i = Speculative Component, demand for money as an asset, if alternative asset returns more than money, increases demand for that asset and lowers L
- Varies inversely with the nominal interest rate, i
H shows the sensitivity of money demanded to changes in interest, the elasticity of money demand / interest sensitivity, varies a lot throughout the world

Question 3

Why does money demand increase

Answer 3

When we consume more, we need money to obtain the goods and services we want, hence our demand for money increases

Also when i increases, people will hold less money as it costs more to obtain and you receive more for storing it, therefore the demand for L decreases, there is an increased OC of holding money when i increases

Question 4

Graphing the Money Demand Curve, Slope & Y-Intercept

Answer 4

• I (y-axis) L (x-axis), downward sloping

As we want to see the effects of a change in interest rates on L (x-axis), must make i (y-axis) the subject of the money demand function.

L = KY - Hi

• > Hi = KY - L
• > i = KY - L / H

To find th Y-intercept, set L to 0, i=ky/h > 0, gives us a starting point
An increase in Y moves the intercept upwards, shifting the demand curve outwards

Slope is determined by H, so if H is higher, the demand for money curve is flatter, if H is smaller, the demand for money curve is more steep

Question 5

Money Supply

Answer 5

Is determined by an independent central bank, it’s exogenous. its a perfectly inelastic vertical line
If there is expansionary monetary policy, the curve shifts outwards as there is an increase in the money supply

Question 6

Asset Market Equilibrium, LM Curve Equation, Slope & Y-Intercept

Answer 6

Occurs where L = M / P (liquidity = real value of money)

• Meaning M/P = KY - Hi
• Re-arrange
• -> hi = KY - M/P –> i = KY - M/P / H - This is the LM Curve
• Set Y = 0 to find Y intercept
• -> - M/P / H < 0
• To find slope, use trick of finding what horizontal axis is being * by, Y is being * by K/H, this is the slope
• Can see H has effect on the curve, the smaller H is the steeper the curve, the bigger H the flatter

Question 7

LM Curve & Equation, Slope & Position

Answer 7

Found by re-arranging L = M / P to make i the subject

• Gives us: i = KY - M/P / H
• Starts below 0
• i (y-axis) y (x-axis), upward sloping, starts below 0
• Means it’s upward sloping & the interest elasticity (h) is the main determinant of position of the slope(smaller = steeper)
• The determinant of the position is the real money supply ( M / P )
• A rise in M (or fall in P) will shift LM down (up)

Question 8

Basic Money Multiplier & Finding

Answer 8

Basic only considers the asset market, it shows the effect of change in M on Y

• To find rearrange money market E and set Y as the subject, gives: Y = H*i + M/P / K
• Then partially differentiate (use trick) with respect to M:
  1/K > 0
• As it is positive shows positive effect of monetary policy on income.

Basic money multiplier = 1 / K > 0

Question 9

Money / Asset Market Equilibrium

Answer 9

M / P = L

M / P = KY - hi