Question

Use the liquidity preference model to show how an increase in money supply (M) shift the LM curve. (Draw two diagrams: the market for real money balances and the LM

curve)

Thanks!

Answer 1

According to the liquidity preference theory, there are three motives that determine the demand for liquidity.

First, the transactions motive states that individuals have a preference for liquidity in order to guarantee having sufficient cash on hand for basic day-to-day needs such as buying groceries, paying rent and/or the mortgage. Higher costs of living mean a higher demand for cash/liquidity to meet those day-to-day needs. It is the money held for transactions motive which is a function of income. The greater the level of income, the greater the amount of money held for transactions motive and therefore higher the level of money demand curve.

Second, the precautionary motive relates to an individual's preference for additional liquidity in the event that an unexpected problem or cost arises such as unforeseen costs like car repair, that requires a substantial outlay of cash.

Third, stakeholders may also have a speculative motive. When interest rates are low, demand for cash is high as the opportunity cost of holding cash in hand is low. When higher interest rates are offered, investors give up liquidity in exchange for higher rates. Thus, the speculative demand for money depends on the rate of interest which is the cost of holding money. This is because by holding money rather than lending it and buying other financial assets, one has to forgo interest.

Thus, the liquidity preference model is a model to support the liquidity preference theory that the demand for cash (liquidity) held for speculative purposes and the money supply, determine the market rate of interest.

Thus, Md = L(Y, r) : Demand for money

The intersection of the various money demand curves corresponding to different income levels with the supply curve of money fixed by the monetary authority would give the LM curve. The money supply is held constant along the LM curve.

As the money supply increases, there is the rightward shift in the LM curve.

The money market is in equilibrium at point E. If money supply increases from Ms0 to M1s the rate of interest falls from r0 to r1 (at a given level of income Y0) as the money market reaches new equilibrium at point F.

As a result the LM curve shifts to the right, indicating lower interest rates at all levels of income.

In short, an increase in the money supply shifts the LM curve downward and to the right.

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