1 G IS 2 The horizontal distance of the IS shift equals Y PE r Y PE Y Y 1 Y 1

# 1 g is 2 the horizontal distance of the is shift

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33 Money supply The supply of real money balances is fixed: M/P real money balances r interest rate 33 s M P M P s M P M P
34 Money demand Demand for real money balances: M/P real money balances r interest rate L ( r ) 34 s M P M P ( ) d M P L r
35 Equilibrium The interest rate adjusts to equate the supply and demand for money: M/P real money balances r interest rate L ( r ) r 1 35 s M P M P ( ) M P L r
36 How the Fed raises the interest rate To increase r , Fed reduces M M/P real money balances r interest rate L ( r ) r 1 r 2 36 1 M P 2 M P
37CASE STUDY: Monetary Tightening & Interest RatesLate 1970s: π> 10%Oct 1979: Fed Chairman Paul Volcker announces that monetary policy would aim to reduce inflationAug 1979–April 1980: Fed reduces M/P8.0%Jan 1983: π= 3.7%How do you think this policy change would affect nominal interest rates? How do you think this policy change would affect nominal interest rates? 37
38 Monetary Tightening & Interest Rates, cont. Δ i < 0 Δ i > 0 8/1979: i = 10.4% 1/1983: i = 8.2% 8/1979: i = 10.4% 4/1980: i = 15.8% flexible sticky Quantity theory, Fisher effect (Classical) liquidity preference (Keynesian) prediction actual outcome The effects of a monetary tightening on nominal interest rates prices model long run short run 38
39 The LM curve Now let’s put Y back into the money demand function: The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is: 39 ( , ) M P L r Y d M P L r Y ( , )
40 Deriving the LM curve M/P r L ( r , Y 1 ) r 1 r 2 r Y Y 1 r 1 L ( r , Y 2 ) r 2 Y 2 LM (a) The market for real money balances (b) The LM curve 40 1 M P
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42 How Δ M shifts the LM curve M/P r L ( r , Y 1 ) r 1 r 2 r Y Y 1 r 1 r 2 LM 1 (a) The market for real money balances (b) The LM curve LM 2 42 1 M P 2 M P
43 NOW YOU TRY Shifting the LM curve Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions. Use the liquidity preference model to show how these events shift the LM curve. 43 43
44 ANSWERS Shifting the LM curve 44 M/P r L ( r , Y 1 ) r 1 r 2 r Y Y 1 r 1 r 2 LM 1 (a) The market for real money balances (b) The LM curve LM 2 L ( r , Y 1 ) 44 1 M P
46 C H A P T E R S U M M A R Y 1. Keynesian cross