Building the LM curve - 4b

What does the LM curve show

That the interest rates adjusts to balance the supply and the demand of money

Define money

Money is the assets that can be readily used to pay for a transaction

Fully liquid

little to no interest

Define bonds

Bonds are assets which can be purchased for a sum of money and cannot be used for immediate transactions

Bonds generate interest for the owner and can appreciate and be sold for a greater price than they were originally purchased for

What is money supply

Quantity of money available in the economy

A simplified view is that money supply is determined by monetary policy

What is money demand

The amount of money individuals hold not in assets/ wealth

Draw money supply

What is the formula for real money balances

Explain it

M = money supply, P = price

They are both fixed as price is fixed in the short run and M is an exogenous policy set by the central bank

Draw money demand

Why is the demand for money determined by the interest rate

The opportunity cost of holding money is the interest rate this is because investing the money with a higher interest rate can pay off with lots of money

What is the formula for money demand

Draw money supply and demand together

Show a fall in the money supply

How does income affect the market for real balances

Show formula

Income affects the demand for money, high income - high expenditure - people need more money on hand.

So greater income = greater money demand

How can the change in income and output be shown on a graph (draw it)

Explain the LM curve

Each point on the LM curve represents an equilibrium in the money market

But also more income = more demand for money and thus higher interest rates showing interest rates depend on income

So the LM curve slopes upward

Use the LM curve to show how interest rates also depend on the supply of money

Explain why the central bank may buy gov bonds from the public

The money paid for bonds increases the monetary base and so increase the money supply - expansionary

What is the monetary base

Very liquid money (Notes and coins.ect.)

Why would the government sell bonds

When the central bank sells bonds to the public the money it receives reduces the monetary base and decreases money supply. Contractionary

What are the full formulas for the IS and LM models

Draw the IS and LM model

Just a good diag