GRIPS Macroeconomics II

Fall II Semester, 2016

Lecture 3: Keynesian AD Curve (1): The Money Market and the LM Curve
Junichi Fujimoto
December 8, 2016

The Money Market and the Interest Rate

1.1 Nominal and Real Interest Rate

The nominal interest rate is the interest rate usually reported, and is what one must pay for borrowing money.
However, for a given nominal interest rate (say 10%), the true cost of borrowing diers a lot when the ination rate
is 0% and when it is 10%. The real interest rate takes this into consideration, and corrects for the eect of ination.
Let it and rt denote, respectively, the nominal and real interest rate in period t. Let Pt and Pt+1 denote,
respectively, the price level in period t and t + 1. Letting t+1 be the ination rate from period t to t + 1,
t+1 =

Pt+1 Pt
Pt+1
=
1.
Pt
Pt

(1)

Someone who deposits 1 yen in period t can receive 1 + it yen in period t + 1. In terms of goods, one can buy,
t
units of goods in period t + 1.
with 1 yen, P1t units of goods in period t; by making a deposit, one can buy P1+i
t+1
The real interest rate is the interest rate measured in terms of goods, so it is given by
1
1 + it
(1 + rt ) =
.
Pt
Pt+1

Using (1),
1 + it = (1 + rt )

(2)

Pt+1
= (1 + rt )(1 + t+1 ).
Pt

When rt and t are not very large, their product becomes quite small. So, as an approximation, we obtain
it = rt + t+1 .

(3)

This is called the Fisher equation. The Fisher equation implies that, when there is no change in the real interest
rate, changes in the ination rate are directly reected in the nominal interest rate.
When a borrower and a lender agree on a loan contract, they do not know the ination rate over the term of
the loan. Thus, it is important to distinguish between the ex ante real interest rate (which approximately equals
i E , where E is the expected ination rate), which is the real interest rate expected by the agents, and the ex
post real interest rate (which approximately equals i ), which is the realized real interest rate.
Since the actual ination rate is unknown when the nominal interest rate is determined, the following version
of the Fisher equation is more appropriate as an expression explaining the nominal interest rate.
it = rt + Et [t+1 ] .

(4)

1.2 Interest Rate and Money Demand

In the classical theory's quantity theory of money, the demand for real money balances depends only on income. In
contrast, Keynes's theory of liquidity preference assumes that the demand for real money balances depends also on
the interest rate. This is a natural idea, since the opportunity cost of holding money is the nominal interest rate.
More precisely, the Keynesian real money demand function is given by L(i, Y ), or equivalently, by L(r + E, Y ).
This is a decreasing function of i (and accordingly of r), and an increasing function of Y .
1

MS
P

LM

r1
L(r , Y1 )

r2
L(r , Y2 )

Y2

Y1

M
P

Figure 1: Derivation of the LM curve

1.3 Money Supply

As before, let us assume here that the central bank can directly control the money supply (Chapter 4 you studied
in Macro I discusses the central bank's instruments to control the money supply).

LM Curve

2.1 Derivation of the LM Curve

The LM curve plots the combination of the interest rate and income Y for which the money demand (L: Liquidity
Preference) equals the money supply (M: Money Supply). As the interest rate, it is natural to consider the nominal
interest rate i, which is the opportunity cost of holding money. However, since we want to later plot the LM curve
on the same diagram as the IS curve, let us assume that the expected ination rate is constant, and use the real
interest rate r.
In order to obtain the LM curve, assume that P is constant, and plot r on the vertical axis, the supply of
S
real money balances MP and the demand for real money balances LD on the horizontal axis, and draw the curve
L(r, Y ) for two dierent levels of income, Y1 and Y2 . The corresponding interest rates, r1 and r2 , are obtained at
S
points where these two curves intersect with the vertical MP curve. Then, plot r on the vertical axis and Y on the
horizontal axis, and connect the two points, (r1 , Y1 ) and (r2 , Y2 ). This gives us an upward sloping LM curve (see
Fig 1. More precisely, we need to follow this procedure for all possible values of Y , not just for Y1 and Y2 ).
The intuition for the upward sloping LM curve is as follows. Suppose income rises from Y2 to Y1 . This increases
S
the transaction motives for holding money, so the demand for real money balances exceeds its supply, MP . To
recover the money market equilibrium, the interest rate must rise and lower the demand for real money balances.
2.2 The LM Curve and the Quantity Equation of Money

The quantity theory of money assumes that V and k in the quantity equation M V = P Y and M = kP Y are
constant. This corresponds to assuming a vertical LM curve. If we relax this assumption and consider that V is
an increasing function of r (or that k is a decreasing function of r), we obtain the Keynesian upward sloping LM
curve. Intuitively, a rise in the interest raises the cost of holding money. Then, V rises since people wish to spend
money more quickly, and k falls since people wish to hold less money for a given amount of income.
2.3 When Does the LM Curve Shift ?

Let us think of several situations in which the LM curve shifts.

2

(a) Changes in the money supply

When the money supply M S increases, the vertical MP curve shifts to the right. Thus, for any given Y , r falls,
hence the LM curve shifts downwards (or equivalently to the right).
S

(b) Changes in the price level

When the price level P falls, the supply of real money balances
(or to the right), just like in (a).

MS
P

rises, and so the LM curve shifts downwards

(c) Shocks to liquidity preference

If an increased use of credit cards make people hold less money, L(r, Y ) shifts to the left. Then the interest rate at
S
its intersection with the vertical MP curve falls. Thus, the LM curve shifts downwards (or to the right).
2.4 Mathematical Example

As in the example below, we can consider a household's utility maximization that yields the LM curve.
max U
M
P

Y(

M h
)
P

s.t. Y = Y max i(

(5)
M
)
P

(6)

Here, Y max denotes income when the household does not hold money at all. Substituting (5) into (6),
max U = (Y max i(
M
P

M
M
))( )h .
P
P

(7)

So the rst order condition is

i(

M
M
M
M h
) = (Y max i( ))h( )h1 = hY ( )h1 .
P
P
P
P

(8)

Rearranging and noting that demand and supply for real balances are equal in equilibrium, we obtain the LM curve
M
h
h
= Y =
Y.
P
i
r + E

(9)

2.5 Practice Questions

<Q1> Suppose the demand for real money balances is given by

L(r, Y ) = l0 lr r + lY Y.

Answer whether the following statements are true or false.

1. Suppose the demand for real money balances falls autonomously (i.e., l0 falls). The greater the interest
sensitivity of the demand for real balances (i.e., the larger the lr ), the greater the rightward shift of the LM
curve.
2. The greater the income sensitivity of the demand for real money balances (i.e., the larger the lY ), the atter
the LM curve.
<Q2> In the mathematical example above, suppose the utility function is given by
U=

M 1
P

+ Y 1
,
1

instead of (5). Obtain the expression for the LM curve.

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