Question

Problem 5: LM Relation

5a. (1pt) What does LM mean here?

5b. (1pt) Which market equilibrium does LM describe?

5c. (2pt) If the interest rate goes up, how would real money demand change. Explain why.

5d. (2pt) If output goes up, how would real money demand change. Explain why.

5e. (4pt) Derive the LM curve graphically.

Don't say this incomplete, just looking for general comprehensive answers without any numbers.

Answer 1

Answer -

a) LM is a part of Keynesian macro economics model-

IS-LMIS-LM

WHERE

IS means -Investment-Saving

LM means - Liquidity preference and Money supply.

which illustrates how the goods and services (IS) market interact with the market for loanable funds(LM) or the money market.

b.) LM describes about money market Equibrium.

The LM curve demonstrates the balance of interest rates and real income levels for which the money market is in equilibrium. This shows that the demand for money is the same as the supply of money. The independent variable for the LM curve is income and the interest rate is the dependent variable.

c.) If the amount of money demanded increases, the price of money (interest rates) also rises, causing the demand curve to rise and shift to the right. A decrease in demand would shift the curve to the left.

d.) The demand for money shifts as the nominal amount of output increases. With the nominal rate of interest, that goes in, If the amount of money demanded increases, the price of money (interest rates) also rises, causing the demand curve to rise and shift to the right.

e.) Drivation of the LM curve

"The LM curve," L "denotes liquidity, and" M "denotes money, is a graph of real profits, Y, and real interest rate combinations, r, such that the money market is in equilibrium (i.e. supply of real money = demand for real money). The LM curve graphical derivation is illustrated above.

For a given level of Y, the left-hand side of the graph shows money market equilibrium. For instance, the equilibrium real interest rate is 5% when Y = Y0. The LM curve is given by the right-hand-side of the graph. The LM curve is plotted on the vertical axis with the real interest rate and on the horizontal axis with the real revenue (GDP). For a given real interest rate and income pair (r, Y), each point on the LM curve reflects a money market equilibrium.

The money demand curve moves up and right at a higher income level, Y1 > Y0, and a new equilibrium occurs at r = 7 percent. The blue (upper) dot on the LM curve reflects this equilibrium. Similarly, the money demand curve moves down and left at a lower level of income Y2 < Y0 and a new equilibrium occurs at r= 3 percent. The red (lower) dot on the LM cu gives this equilibrium,

The above analysis shows that the LM curve is an upward sloping curve in the graph with r on the vertical axis and Y on the horizontal axis. An intersection between the supply of real money (M / P) and the demand for real money (Ld) represents each point on the LM curve. The LM curve will change whenever the variables we hold constant, other than Y, in the money-supply / money-demand diagram change. M / P and e variables are present. Likewise, real money demand falls, reducing the interest rate, and the LM curve moves down and to the right if predicted inflation rises. We reflect the LM curve functionally as variables

(+) (+)

LM (M0/P0π, Squire e)

The (+) sign means that the LM curve is moved down and to the right by a rise in the variables.