The Money Stock and the Money Market: The LM Curve

The intersection of the IS as well as LM curves determines short-run equilibrium values of real GDP when the money stock is fixed. However in today do world central banks manipulate the money stock to peg interest rates, they don’t embrace the money stock fixed.

Therefore the IS-LM analysis is of limited usefulness. It is better in mainly cases to think about the IS curve and interest rates as well as to forget about the LM curve.

However if you need the full IS-LM analysis here it is. Evoke three facts about business and household demand for money where ‘demand for money’ is economist-speak for the quantity of readily-spendable liquid assets held in one’s portfolio:

•    Money stipulate is proportional to total nominal income P x Y.
•    Money stipulates has a time trend, the result of slow changes in banking-sector structure and technology.
•    Money stipulates is inversely related to the nominal interest rate.

Money demand is inversely associated to the nominal interest rate because the nominal interest rate is the opportunity cost of holding money. Money balances earn efficiently zero real interest and over time they lose their power to purchase real, useful goods as well as services at the rate of inflation π. If money balances were sold in addition to the proceeds put into some other investment they would earn the prevailing market real interest rate r. Therefore the opportunity cost of holding wealth in the form of money is the nominal interest rate i = r + π^e: the amount of the real interest rate r and the expected inflation rate π^e.

To keep our model easy, we ignore the time trend in velocity as well as write the demand for money as the function:

For the reason that the left hand side is the nominal money stock divided by the price level, this equation symbolize real money demand—a demand for an amount of liquid power to purchase goods and services, rather than requirement for a stack of dollar bills. This equation demonstrate that money demand is proportional to real GDP Y: the higher is real GDP the more real money balances people wish to hold. The plus (positive) sign in front of the Vi parameter means that velocity is an increasing function of the nominal interest rate and therefore money demand is a decreasing function of the nominal interest rate. The elevated is the nominal interest rate, the higher is the chances cost of holding money as well as the lower is the real quantity of money demanded.

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