Money Demand

  • Economy has a need for money; there exists a demand for money
  • Real money = M/P, so M/P = Y/V where V is the velocity of money (taken from quantity theory of money)
  • Other reasons people hold money
    • Transactions; to make purchases
    • Precautionary; for emergencies
    • Specualation; to make a bet on interest rates or markets
    • All motives depend on the nominal interest rate i
  • Therefore, money demand depends both on Y and i; demand function = L(Y, i)
r=i−πL(Y,r), where ∂L∂Y>0,∂L∂r<0r = i - \pi \\ L(Y, r) \text{, where } \frac{\partial L}{\partial Y} > 0, \frac{\partial L}{\partial r} < 0
  • The traditional Keynesian market focuses on equilibrium in the money market; intersection of money demand and money supply

Money Supply

  • The Central Bank sets the money supply to be some constant amount

Money Market Equilibrium

  • The equilibrium exists at the point where the money supply is equal to the constant amount (set by central bank) and the real interest rate corresponds to the interest rate on the money demand curve
  • The set of all r and Y that results in money market equilibrium is known as the LM curve
  • Equation for curve: L(Y, r) = M/P
    • The LM curve is upwards sloping because an increase in Y means that r has to increase to match M/P
    • Increase in money supply = LM curve shifts downwards

IS-LM Model

  • Downwards sloping IS curve (Y(r)) and upwards sloping LM curve (r(Y))
  • Very similar to IS-MP curve; LM curve essentially shows how the government would set interest rates given a monetary base and a GDP
  • In this model, targeting the money supply and targeting the interest rate is the same, but most banks target interest rate because it’s more efficient
    • Investment demand depends on interest rates, so targeting interest rates targets demand more directly

Differences in IS-LM and IS-MP

  IS-LM IS-MP
Central Bank Targeting money (M/P) Targeting r
Money Supply Fixed Varies as needed to hit the r target
Fixed in short run M/P, prices, inflation (constant at 0) inflation (not prices)
Inflation Hard to model Easy to model via IA curve
When developed 1930s (Keynes) 1990s, 2000s
Good model for Gold standard, Great Depression, etc; whenever M/P fixed Inflation, unconvential monetary policy, financial crises