Theory of Liquidity Preference and LM Model

Question 1

How can Income be saved? (Two Ways)

Answer 1

• Saved in Cash- Coins, Notes etc
• Saved in Bond-Bearing Assets

Question 2

What is money? What is the categorisation of money?

Answer 2

• Money is a stock of assets that can be readily used to make transaction
• It pays little/no interest
• It is a fully liquid asset
• Broad Money = Notes + Coins + Demand Deposits
• Narrow Money = Broad Money + Other Demands

Question 3

What is a bond?

Answer 3

• Bonds are interest-bearing assets that cannot be used for settling direct payments

Question 4

What are the 2 Types of Financial Markets? What is the relationship between the two?

Answer 4

• The Money Market and the Bond Market
• Impacts on the Money market have opposite effects on the bonds market
• Holding of money or bonds will depend on the individual level of transaction and the interest rate of the bonds

Question 5

What are some functions of money?

Answer 5

• Medium of Exchange- Money can be used to purchase goods and services
• Store of Value- Purchasing Power can be transferred from the Present to the Future
• Unit of Account- Money is a common unit to measure value

Question 6

How is Money Supply Controlled?

Answer 6

• Monetary Policy (Set by a Central Bank) is used to control the quantity of money available within an economy
• To raise IR, Central Banks reduce the Money Supply and the IR increases (PoM Increases)

Question 7

What is the Theory of Liquidity Preference? What question does it aim to answer?

Answer 7

• Shows the relationship between Dm and Sm
• Aims to see how changes in the interest rate impacts the Money Supply and Money Demand

Question 8

What are some assumptions of the Liquidity Preference Model?

Answer 8

• SR (PL = Constant)
• Closed economy

Question 9

What are the variables in the equation of LM? Are any exogenous?

Answer 9

• M = Money Supply (Exogenous)
• P = Prices (Fixed{In the SR})
• i= Nominal Interest Rate
• Due to fixed prices, 0 inflation so i=r

Question 10

What is the Money Supply and Money Demand Equation?

Answer 10

• Money Supply = M/P
• Money Demand = L(r)

Question 11

How does the Central Bank manipulate the Bonds Market?

Answer 11

• By using Open Market Operations (Buying/Selling Bonds)
• Expansionary: Buy Bonds, higher Sm, higher Db, lower r, higher Pb
• Contractionary: Sell Bonds, lower Sm, lower Db, higher r, lower Pb

Question 12

What is the Equation for the Current Bond Price (Pπ)?

Answer 12

• Pπ = Px / (1+iπ)
• Derived from the iπ equation :
  Px - Pπ / Pπ
• Where Pπ is the Current Bond Price
• And Px is the Future Bond Price

Question 13

What is the LM curve? Give the equation

Answer 13

• The LM Curve summarises changes in the equilibrium interest rate
• M / P = L (r, Y)

Question 14

How does the IS-LM model interact?

Answer 14

• Looks like a S&D graph, where LM is S and IS is D
• When IS-LM meet, goods market and financial market are linked

Question 15

What is the relationship between the LM curve and the Dm curve?

Answer 15

• As Y1-> Y2, Dm increases, which causes increase in real IR
• This will shift the LM curve upwards

Question 16

How can the Government utilise fiscal and monetary policy to impact the LM model?

Answer 16

-Expansionary Fiscal Policy: G rises, Y increases, Dm rises and r rises- This could reduce Investment and AD
-Expansionary Monetary Policy: Sm rises, r falls and Y increases- This could increase Investment and AD