4.

Money market
equilibrium: the LM curve
Abel, Bernanke and Croushore
(chapters 7 and 9.3)

I. What Is Money? (Sec. 7.1)

A) The functions of money
1. Medium of exchange

a. Barter is inefficientit requires a double

coincidence of wants
b. Money allows people to trade their labor for
money, then use the money to buy goods and
services in separate transactions
c. Money thus permits people to trade with less
cost in time and effort
d. Money also allows specialization, since trading
is much easier, so people dont have to produce
their own food, clothing, and shelter

I. What Is Money? (cont.)

A)

The functions of money (cont.)

2. Unit of account

a. Money is the basic unit for measuring economic value

b. This simplifies comparisons of prices, wages, and incomes
c. The unit-of-account function is closely linked with the medium-ofexchange function
d. But countries with very high inflation may use a different unit of
account, so they dont have to constantly change prices

3. Store of value

a. Money can be used to hold wealth

b. Most people use money only as a store of value for a short
period and for small amounts, because it earns less interest than
money in the bank

Discuss what happens in an hyperinflation episode (for example,

Germany in the 1930s)

I. What Is Money? (cont.)

B)

Measuring moneythe monetary aggregates and the Money Supply

1.Distinguishing what is money from what isnt money is sometimes difficult
a. For example, bank deposits may be transformed into cashed with some
cost , but give a higher return than bank checking accounts: Are they money?
b. Theres no single best measure of the money stock
2.The M1 monetary aggregate. Narrow definition for Money Supply.
a. Consists of currency and travelers checks held by the public, and checking
account balances (which pay no interest)
b. All components of M1 are used in making payments, so M1 is the closest
money measure to our theoretical description of money
3. The M2 monetary aggregate. Broad definition for Money Supply.
a. M2 = M1 + less moneylike assets
b. Additional assets in M2 include small savings deposits, and balances from
noninstitutional monetary market funds (MMMF) (MMDA)
(1) Savings deposits bear interest and have a fixed term (substantial
penalty for early withdrawal). Quasi-money (liguidity cost and pay
interest).
(2) MMMFs invest in the secondary market for very short-term securities
(for example, government bonds). Quasi-money (liguidity cost and pay
interest).
4. The M3 monetary aggregate.

M3=M2 + institucional MMMF + large saving deposits+ eurodollars

II. The demand for money: the Baumol-Tobin model

A transactions theory of money demand
notation:

PY = total nominal spending, done gradually over

the year
i = nominal interest rate on savings account
N = number of trips consumer makes to the bank
to withdraw money from savings account
F = cost of a trip to the bank
(e.g., if a trip takes 15 minutes and
consumers wage is 12/hour, then F = 3)

II. The demand for money: the Baumol-Tobin

model
Money
holdings

PY

N=1
Average
= PY/ 2

1
Money holdings with one trip to the bank

Time

II. The demand for money: the Baumol-Tobin

model
Money
holdings

N=2

PY
PY/ 2

Average
= PY/ 4

1/2
Money holdings with two trips to the bank

Time

II. The demand for money: the Baumol-Tobin

model
Money
holdings

N=3

PY

Average
= PY/ 6

PY/ 3

1/3
Money holdings with three trips to the bank

2/3

Time

II. The demand for money: the Baumol-Tobin

model
The cost of holding money
In general, average money holdings = PY/2N
Foregone interest = i (PY/2N )
Cost of N trips to bank = P F N
Thus,

Total cost= i (PY/2N ) + P F N

Given P,Y, i, and F,

consumer chooses N to minimize total cost

II. The demand for money: the Baumol-Tobin

model
Finding the cost-minimizing N:

Total cost= i (PY/2N ) + P F N

Take the derivative of total cost with respect to
N, set it equal to zero:

dTC/dN = - (iPY/2N) + P F = 0

Solve for the cost-minimizing N*

II. The demand for money: the Baumol-Tobin

model

N*

Finding the cost-minimizing N

II. The demand for money: the Baumol-Tobin

model
The money demand function
The cost-minimizing value of N :
To obtain the money demand function,

plug N* into the expression for average real money holdings, M/P = PY/2N
Average real Money
M/P= (PY/2N*)/P= Y/2N*
M/P= Y/(2(iY/2F)^0.5)=(YF/2i)^0.5

Money demand depends positively on P, Y and

F, and negatively on i.

II. The demand for money: the Baumol-Tobin

model
The Baumol-Tobin real money demand function:

B-T nominal money demand implies:

price elasticity =1.0
income elasticity = 0.5,
interest rate elasticity = 0.5
Resembles LM curve, positive relationship between
Y and i to clear money market

II. The demand for money: the Baumol-Tobin

model
Summary of the Baumol-Tobin model
a transactions theory of money demand,
stresses medium of exchange function
Real money demand (Md/P) depends positively on
spending (Y), negatively on the nominal interest
rate (i),
and positively on the cost of converting
non-monetary assets to money (F)
Microfoundation for the LM curve

slide 14

II. The demand for money: the Baumol-Tobin

model
Alternative model. Quantity theory of money: Real money

demand is proportional to real income

a. Money velocity definition V=PY/ M,
b. Assuming constant velocity and money market
equilibrium, we obtain this money demand formulation in the
Quantity theory of money:

where k = 1/V

c. But velocity of M1 is not constant; it rose steadily from

1960 to 1980 and has been erratic since then

Md/P = kY

(1) Part of the change in velocity is due to changes in interest

rates in the 1980s
(2) Financial innovations also played a role in velocitys decline
in the early 1980s

d. M2 velocity is closer to being a constant, but not over

short periods

III. The LM curve

LM curve represents the money market equilibrium
If the economy is on some point that belongs to the LM curve

the amount of money demanded is equal to the amount of

money supplied, Md = Ms
Md is decided by the private sector (households) as in the BT
model.
Md = P L(Y, i) where the L money demand function depends
positively on Y and negatively on i
Md = P L(Y, r+e)
Ms is decided by the central bank
Open market operations

Open market purchase to increase Ms (monetary expansion)

Open market sale to decrease Ms (monetary contraction)

Ms as a monetary policy instrument

III. The LM curve (cont.)

1.

Ms /P = L(Y, r + e) real money supply = real money demand

a. Ms is determined by the central bank

b. e is fixed
c. The labor market determines the level of employment; using
employment in the production function determines Y
d. Given Y, the goods market equilibrium condition determines r

2.

With all the other variables determined, the money market

equilibrium condition determines the price level

a. P = M/L(Y, r + e)
b. The price level is the ratio of nominal money supply to real
money demand
c. For example, doubling the money supply would double the
price level

III. The LM curve (cont.)

3. Equilibrium in the money market requires that the

real money supply equal the real quantity of money

demanded

4.

a. Real money supply is determined by the central

bank and isnt affect by the real interest rate
b. Real money demand falls as the real interest rate
rises
c. Real money demand rises as the level of output
rises

The LM curve (Figure 9.4) is derived by plotting

real money demand for different levels of output and
looking at the resulting equilibrium

III. The LM curve (cont.)

Positive relationship between output (Y) and the expected real interest
rate (r) to restore the money market equilibrium

III. The LM curve (cont.)

5. The LM curve shows the combinations of

the real interest rate and output that clear the

money market
a. Intuitively, for any given level of output, the
LM curve shows the real interest rate
necessary to equate real money demand and
supply
b. Thus the LM curve slopes upward from left
to right

Money growth and inflation

The inflation rate is closely related to the growth rate

of the money supply. High-inflation countries often

have rapid money growth
Rewrite LM curve as:
P/P = M/M L/L
If money market is in equilibrium, the inflation rate
equals the growth rate of the nominal money supply
minus the growth rate of real money demand
Discuss inflation targeting as a central-bank strategy
for monetary policy

Figure 7.3 The relationship between money growth

and inflation (1995-2001)

IV. Factors that shift the LM curve

a. The LM curve shifts to the right because of
(1) an increase in the nominal money supply
(2) a decrease in the price level
(3) an increase in expected inflation
(4) a decrease in the nominal interest rate on money
(5) a decrease in wealth
(6) an increase in the efficiency of payment
technologies (lower F in the BT model)
b. The LM curve shifts to the left when the opposite

happens to the six factors listed above

IV. Factors that shift the LM curve (cont.)

Example 1. An increase in the money supply

IV. Factors that shift the LM curve (cont.)

Example 2. An increase in the money

demand