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To evaluate this argument we discuss how changes in

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Unformatted text preview: = M¯,/P¯,, therefore the money supply curve plotted against the interest rate is vertical. The demand for real money balances (M/P)d = L(r). Because the interest rate is the opportunity cost of holding money, the money demand curve is negatively sloping. Page 32 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 The interest rate adjusts to equilibrium because whenever the money market is not in equilibrium, people try to adjust their portfolios of assets, and in the process, alter the interest rate. For example, if the interest rate is below equilibrium, quantity demanded exceed the quantity supplied, so individuals try to obtain money by selling bonds or making bank withdrawals. To attract now scarcer funds, banks and bond issues respond by increasing the interest rates they offer, bring r to equilibrium. If the Bank of Canada increases the money supply, (M/P)s shifts right and the interest rate decreases. The opposite is true if the Bank of Canada decreases the money supply. The LM Curve Greater income implies greater money demand, and higher interest rates imply lower money demand. Hence, (M/P)d = L(r, Y). The quantity of real money balances demanded is negatively related to the interest rate and positive related to income. We derive the LM curve from the market for real money balances functions. An increase in income shifts money demand right, causing an increase in the real interest rate r. Therefore, higher income leads to a higher interest rate. The LM curve plots this relationship between Y and r. The higher the level of income, the higher the demand for real money balances, and the higher the equilibrium interest rate. For this reason, the LM curve slopes upward. The LM curve is drawn for a given supply of real money balances. If real balances change, the LM curve shifts. Suppose the Bank of Canada decreases the money supply M. This causes the supply of real balances to fall from M1/P to M2/P. This fall in the money supply raises the interest rate that equilibrates the money market. Hence, a decrease in real balances shifts the LM curve upward. In summary, the LM curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for real money balances. The...
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