• Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

Derive the LM curve under the theory of liquidity preference. Does this depend on the real or nominal interest rate?

Extracts from this document...


Derive the LM curve under the theory of liquidity preference. Does this depend on the real or nominal interest rate? What happens to the LM curve when there is: a. an increase in the price level b. an increase in the money supply c. an increase in disposable income The theory of liquidity preference, introduced in the General Theory, is Keynes' view on how the interest rate is determined in the short run. It is a demand and supply model of the economy's most liquid asset, money. However, money, in the model, is expressed in terms of the amount of goods and services it can purchase, real money balances. The supply of real money balances is an exogenous policy variable chosen by the Central Bank. It is therefore assumed to be fixed, and furthermore, it does not depend on the interest rate. Consequently, the supply curve for real money balances is vertical. The demand for real money balances however, does clearly depend on the interest rate which should be obvious from the shape of the demand curve for balances, a downward sloping demand curve. The theory of liquidity preference suggests that the interest rate is a determinant of how much money people want to hold. ...read more.


As we can then see from the diagram below (a), this causes an increase in the interest rate from r1 to r2. These changes are then summarized in the LM curve shown in diagram (b) below. The LM curve plots the relationship between income and the interest rate. The higher the level of income, (the higher the demand for transactions and therefore the higher the demand for money balances) the higher the equilibirum interest rate. (The higher the rate of interest that equilibriates the money market). Thus we have derived the LM curve under the theory of liquidity preference. a. An increase in the price level As noted earlier, the price level is an exogenous variable in the IS-LM model. However, it affects the supply of money balances. An increase in the price level has the affect of lowering purchasing power, and consequently, it reduces the amount of real money balances supplied. In the diagram below (a), this is depicted by a shift to the left of the supply curve for real money balances. Diagram (b) shows what happens to the LM curve: Income does not change in this situation. What does happen is that the increase in prices, leading to a fall in the supply of real balances, causes the interest rate to rise. ...read more.


It seems, prima facie, that the interest rate we are concerned with in deriving the LM relation is the nominal rate of interest. This is because, the money demand function depedns on the nominal rate of interest. As mentioned above, when we decide how much money to hold, we take into account the opportunity cost of holding money rather than financial investment. Money pays a zero nominal interest rate, whereas bonds (or savings accounts etc) pay a nominal interest rate of i. Hence, the opportunity cost of holding money is just the difference between the two interest rates, i - 0 = i, which is just the nominal interest rate. Therefore, money demand depends on the nominal interest rate. However, in the IS-LM, which is a short run model, where we assume are nominal rigidities, in this context, sticky prices. Therefore, in IS-LM there is no inflation since the price level is fixed. Recall that the equation for the real rate of interest is: r = i - *, and therefore, i = r + * However, in IS-LM (short-run) there is no * due to the sticky prices. Therefore, if *=0, then; i = r + 0 ==> i = r the nominal rate of interest is equivalent to the real rate of interest, and we can therefore say that the LM curve depends on the real rate of interest. ...read more.

The above preview is unformatted text

This student written piece of work is one of many that can be found in our GCSE Economy & Economics section.

Found what you're looking for?

  • Start learning 29% faster today
  • 150,000+ documents available
  • Just £6.99 a month

Not the one? Search for your essay title...
  • Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

See related essaysSee related essays

Related GCSE Economy & Economics essays

  1. An Empirical Investigation into the Causes and Effects of Liquidity in Emerging

    use values taken from the IMF in 1997. These show that bonds issued by developing countries rose from negligible levels in the 1980's, (less than $3.5 billion in 1989), to $24 billion in 1992, more than $50 billion per annum in the period 1993 - 1995, an unprecedented $102 billion in 1996 and even higher levels in 1997.

  2. "Why did industrialisation depend on agriculture in the USSR?"

    The main features of each are their interpretations of the market. Bukharin favours a free market yet preobrazensky takes a fixed (state controlled)market as the linchpin of the economy.

  1. The Quest for Optimal Asset Allocation Strategies in Integrating Europe.

    in the same region. This finding is consistent with the argument that macro-economic factors may partly drive stock market movements. However, it is difficult to disentangle the impact of EMU from other channels that might also affect European stock integration.

  2. Liberalization: where it has lead us and where it is headed

    There is a saying that the British introduced bureaucracy to India, but the Indians perfected it. As I'm sure many of you know, "red tape" is still in use-literally. It is cloth tape that wraps the files circulating endlessly within the various ministries.

  1. Transaction Cost Theory

    The internalisation of transactions enables the exploitation of economies of scale or of scope1. The extent to which economies of scale can be exploited determines the size of a firm. Under what circumstances will transaction costs be lower when internalised than when left to be negotiated in an external market?

  2. It is impossible to target both the money supply and the rate of interest. ...

    There are various techniques in order to influence and somewhat control the total money supply by affecting the credit amount that banks can create. The Central bank can provide extra money to banks. They may also set their interests rates below that of market rates in order to encourage and allow banks to borrow at a cheaper rate.

  1. Compare and contrast, the assumptions, the predictions and the policy implications of the IS/LM ...

    from I1 to I2 and fall in savings i.e. from S1 to S2, thus the equilibrium national income will be at point 'b', Y2. Taking these assumptions into account and IS curve from figure-1, we can say that higher interest rates are associated with lower national income and vice-versa.

  2. Retailing In India - A Government Policy Perspective

    For instance, the best practice player has 1,600-1,700 vendors - over 400 per region. As a consequence, a retailer needs a large sourcing and quality control team, which raises the costs of procurement. Focusing on fewer national suppliers wherever possible can reduce the sourcing complexity, which will also help meet the cost/quality needs.

  • Over 160,000 pieces
    of student written work
  • Annotated by
    experienced teachers
  • Ideas and feedback to
    improve your own work