# A in what sense is a vertical lm schedule a classical

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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.
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