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# The general form equilibrium the general form of the

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Unformatted text preview: ffective: an increase causes the interest rate socauses the interest down, as showntheFigure 11–18. the LM curve shifts rate to fall, so in LM curve shifts down, as shown in Figure d. 11–18. The LM curve gives the combinations of income and the interest rate at which the d. The LM curve gives the combinations of income and the interest rate at which the supply and supply and demand for real balances are equal, so that the money market is in demand for real balances are equal, so that the money market is in equilibrium. The general form equilibrium. The general form of the LM equation is of the LM equation is M/P = L(r, Y). MSuppose, Y). /P = L(r income Y increases by \$1. How much must the interest rate change to keep the money market in equilibrium? The increase in Y increases money demand. If money demand is extremely sensitive to the interest rate, then it takes a very small increase in the interest rate to reduce money demand and restore equilibrium in the money market. Hence, the LM curve is (nearly) horizontal, as shown in Figure 11–19. M/P = L(r, Y). Suppose income Y increases by \$1. much must must the rate change to keep the Suppose income Y increases by \$1. How How much the interestinterest rate change tomoney mkeep in equilibrium? The increase in Y increases money demand. Y increases money arket the money market in equilibrium? The increase in If money demand is demand. If money the interest rate, then sensitive to the interest rate, the it takes extremely sensitive todemand is extremely it takes a very small increase intheninterest rate to a very small increase in the interest rate to reduce money demand the restore reduce money demand and restore equilibrium in the money market. Hence, and LM curve is equilibrium in the shown market. 11–19. (nearly) horizontal, as money in Figure Hence, the LM curve is (nearly) horizontal, as shown in Figure 11–19. r Figure 11–19 Interest rate d. causes the interest rate to fall, so the LM curve shifts down, as shown in Figure 11–18. The LM curve gives the combinations of income and the interest rate at which the supply and demand for real balances are equal, so that the money market is in equilibrium. The general form of the LM equation is LM IS Y Income, output An example may make this clearer. Consider a linear version of the LM equation: M/P = eY – fr.Note that as f gets larger, money demand becomes increasingly sensitive to the interest rate. Rearranging this equation to solve for r, we find r = (e/f)Y – (1/f)(M/P). We want to focus on how changes in each of the variables are related to changes in the other variables. Hence, it is convenient to write this equation in terms of changes: Δr = (e/f)ΔY – (1/f)Δ(M/P). The slope of the LM equation tells us the change in r when Y changes, holding M fixed. If Δ(M/P) = 0, then the slope is Δr/ΔY = (e/f). As f gets very large, this slope gets closer and closer to zero. If money demand is very sensitive to the interest rate, then fiscal policy is very effective: with a horizontal LM curve, output increases by the full amount that the IS curve shifts. Monetary policy is now completely ineffective: an increase in the money supply does not shift the LM curve at all. We see this in our example by considering what happens if M increases. For any given Y (so that we set ΔY = 0), Δr/Δ (M/P) = ( – 1/f); this tells us how much the LM curve shifts down. As f gets larger, this shift gets smaller and approaches zero. (This is in contrast to the horizontal LM curve in part (c), which does shift down.) 8. Chapter 11 Problem #5 Answer: To stimulate investment the interest rate must fall. The Bank of Canada (BoC) reduces interest rates by using expansionary monetary policy and buying government bonds in the secondary government bond market. If investment increases, other things equal, output will rise but since the goal is to keep output constant, there must be contractionary fiscal policy. The rightward shift of the LM curve due to expansionary monetary policy must be offset exactly by the leftward shift of the IS curve due to contractionary fiscal policy in this case, investment increases while output is constant. Regarding the early 1980’s, government budget deficits and tight (contractionary) monetary policy would shift the IS curve right and the LM curve left and both policies act to increase interest rates. The change in output is indetermina...
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