3.a) In what sense is a vertical
LM schedule a classical sense?
What condition is required for
the alternative extreme case?

•
The slope of LM is determined by the slope of
money demand curve
•
The equation for money demand is given by
•
If the interest elasticity of money demand () is zero
(perfectly inelastic), this will cause the LM curve to
be vertical
•
Since LM is now vertical, the new equation of
money demand is
•
This is when the money demand is unaffected by
interest rate but depends on income
•
This aligns with the classical quantity theory of
money demand in the Cambridge approach,
Md=kPY
•
From this equation, money demand depends on
level of income, holding k and Y constant in the
short run
•
Hence, when
is zero, the vertical LM indicates that
money demand is independent of interest rate
Money demand as a
function of interest rate
Money demand as a
function of income

•
As for the alternative extreme case in which the LM
schedule would be horizontal, the interest elasticity
of money demand is perfectly elastic (
•
Since the interest elasticity of money demand is ,
the money demand curve takes a horizontal slope,
resulting in a flat LM curve
•
A flat LM curve is associated with what Keynes
coined “liquidity trap”
•
A liquidity trap simply means that increasing money
supply will no longer decrease the interest rate
because the interest rate is already at its lowest
level
•
In this situation, people often tend to hold more
money for precautional purposes as an increase in
interest rate will trigger capital loss

3.b) Why might Keynesian be pessimistic
about the ability of monetary policy to
stimulate output in situations such as the
1930s Depression in the US of the
recessions in the 1990s?

•
During the 1930s depression and 1990s
recession, the interest rate during that
time is low. Therefore, we can infer that
the economy was at a liquidity trap.
•
The economy is at a liquidity trap, we can
say that the money demand at that time
was perfectly interest-elastic ().
•
Liquidity trap is shown when the slope of
LM curve is totally flat, as indicated by the
bracket.

•
We can clearly see the effect of the expansion
of monetary policy.
•
The money IS-LM model is at equilibrium
when at interest rate
and output
and the
money market is at equilibrium when at
interest rate
and quantity money of . When
the money authority increases the money
supply, Ms shift to the right from
to .
•
Money demanded will increase from
to
but
interest rate stay at
. Seem that the money
market has absorb all the money effect of the
money supply and thus, unable to spillover to
the good market to increase consumption.
•
Therefore, we see that in the IS-LM model, the
output and interest rate remains unchanged.