Lipsey & Chrystal

Money, Interest and GDP: The LM

Curve
Chapter 19

LIPSEY & CHRYSTAL

ECONOMICS 13e

© Richard Lipsey & Alec Chrystal, 2015. All rights reserved.

 In this chapter you will learn

• There is an important distinction between

nominal money values and real (or relative)
values.
• •Money and other assets are stocks while
GDP and all the final spending variables are
flows.
• We simplify the asset structure in the
economy to just two assets: money and
bonds.

Lipsey & Chrystal: Economics, 13th edition

 • The real interest rate is the nominal rate
minus the inflation rate.
• The market price of a bond is inversely
related to its interest yield.
• The demand for money is positively related to
income and wealth and negatively related to
the rate of interest.

Lipsey & Chrystal: Economics, 13th edition

 • The LM curve shows combinations of GDP
and the interest rate for which money demand
and supply are equal when the money stock
is held constant.
• The LM curve is positively sloped.
• Monetary policy normally works by setting the
interest rate and letting the money supply be
determined by demand.

Lipsey & Chrystal: Economics, 13th edition

 • The purpose of macroeconomics is to
understand what determines real GDP and
why it can deviate from its potential, or normal
capacity, level for significant periods of time.
• We also want to understand why sometimes
we get periods of high inflation, which is
costly in itself but also costly to eradicate
once it takes hold.

Lipsey & Chrystal: Economics, 13th edition

 • Policymakers, in the form of elected
governments or their agents, use the
instruments available to them in an attempt to
ensure both that economic activity stays at as
high a level as is sustainable and that
unacceptably high inflation rates are avoided.
• The tools that can be used for this purpose
are monetary and fiscal policies.

Lipsey & Chrystal: Economics, 13th edition

 Money values and relative values

• Money is our measuring rod for most

economic activity.
• We value our wealth, our incomes, what we
buy, and what we sell, all in money terms.

Lipsey & Chrystal: Economics, 13th edition

 Note!

Money prices are our measure of economic

value.
Money prices allow us to compare different
values at any point in time, as with the
refrigerator and the TV set.
They also allow us to compare values over
time, as with the amount saved now and the
package holiday to be taken later.

Lipsey & Chrystal: Economics, 13th edition

 Money as a veil

• Suppose you tell a man, newly arrived from

Patagonia, that the price of a refrigerator is
£200.
• If he knows no other sterling values, this
would convey no useful information to him.
• But let us say that he entered Britain with
£2000.
• Now he knows that his funds are sufficient to
buy 10 refrigerators.

Lipsey & Chrystal: Economics, 13th edition

 Note!

The point to take away from this discussion

is that the production and consumption of
real goods and services are what matters in
the economy, while nominal values and the
stock of money are conceptually different.

They have a role, but they are a means to an

end not the end itself.

Lipsey & Chrystal: Economics, 13th edition

 The classical dichotomy

• The classical dichotomy asserts a separate

between the real side of the economy and its
monetary side.

Lipsey & Chrystal: Economics, 13th edition

 The neutrality of money

• The classical dichotomy gives rise to what is

called the doctrine of the neutrality of money.
It can be stated in different forms, namely:
– Neutrality with respect to the level of prices
– Money illusion

Lipsey & Chrystal: Economics, 13th edition

 Stocks and flows

• Money and other financial assets are not

flows; they are stocks.
• They are just so many pounds sterling worth
and they are measured at a point in time and
not over a time period.

Lipsey & Chrystal: Economics, 13th edition

 • With monetary assets such as bonds, this link
generally comes from the interest yield on the
asset stock which is a flow in the form of
some percentage of the value of the asset per
period.

Lipsey & Chrystal: Economics, 13th edition

 Money and bonds

• At any moment in time, households have a

given stock of wealth.
• This wealth is held in many forms.
• Some of it is held as money in the bank or in the wallet;
• some is held as short-term securities such as certificates
of deposit and treasury bills;
• some is held as long-term bonds; and
• some as real capital, which may be held directly, in such
forms as farms, houses and family businesses, or
indirectly, in the form of equities (shares) that indicate
part ownership of a company’s assets.

Lipsey & Chrystal: Economics, 13th edition

 • The ease with which any asset can be turned
into money is called its liquidity.
• Liquidity has two aspects:
1. uncertainty about how much money can be
obtained by selling it and
2. how easy it is to make a sale. Money is perfectly
liquid on both counts since it requires no
transaction to turn it into itself!

Lipsey & Chrystal: Economics, 13th edition

 The rate of interest and present value

• A bond is a document that promises to pay a

stated sum of money as interest each year,
and to repay the face value of the bond,
called the ‘principal’ at some future
‘redemption date’, often many years distant.

Lipsey & Chrystal: Economics, 13th edition

 • The time until the redemption date is called
the term to maturity, or, more simply, the term
of the bond. Some bonds, called perpetuities,
pay interest for ever but never repay the
principal.

Lipsey & Chrystal: Economics, 13th edition

 • The present value (PV) of a bond, or of any
asset, refers to the value now of the future
payment or payments to which ownership of
the asset gives a claim.

Lipsey & Chrystal: Economics, 13th edition

 A perpetuity

• A perpetuity that promises to pay £100 per

year to its holder for ever but has no
redemption date or redemption value.
• The present value of the perpetuity depends
on how much £100 per year is worth, and this
again depends on the rate of interest.

Lipsey & Chrystal: Economics, 13th edition

 Note!

The present value of any asset that yields a

given stream of money over time is
negatively related to the current market
interest rate.

Lipsey & Chrystal: Economics, 13th edition

 Present value and market price

• Present value is important because it

establishes the market price for an asset.
• To see this, return to our example of a bond
that promises to pay £100 one year hence.
• When the interest rate is 5 per cent, the
present value is £95.24.

Lipsey & Chrystal: Economics, 13th edition

 Note!

In a free market the equilibrium price of any

asset is the present value of the income
stream that it produces.

Lipsey & Chrystal: Economics, 13th edition

 The rate of interest and market price

• The discussion so far leads us to three

important propositions.
• The first two stress the negative relationship
between interest rates and asset prices:
1. If the current market rate of interest falls, the value of an
asset producing a given income stream will rise.
2. A rise in the market price of an asset producing a given
income stream is equivalent to a decrease in the rate of
interest earned by the asset.
3. The nearer the maturity date of a bond, the less the
bond’s value will change with a change in the market
rate of interest.

Lipsey & Chrystal: Economics, 13th edition

 The prices are those ruling on
24 January 2014

Lipsey & Chrystal: Economics, 13th edition

 The real and the nominal interest rate

• The rate of interest that we have considered

so far is called the nominal rate of interest or
money rate of interest, the two terms referring
to the same thing.
• They express the money return on an asset.

Lipsey & Chrystal: Economics, 13th edition

 Note!

The real rate of interest is approximated by

the nominal rate minus the expected
inflation rate.

Lipsey & Chrystal: Economics, 13th edition

 The supply of money

• For our understanding we use the UK broad

definition of money, M4.
• This includes notes and coins in circulation
outside the banks, plus all sterling deposits
with UK banks and building societies.
• M4 is a nominal amount measured in
monetary units

Lipsey & Chrystal: Economics, 13th edition

 Note!

The nominal quantity of money is

determined by the interaction between the
monetary policy-makers (the central
bank), the banking system, and the
general public.

Lipsey & Chrystal: Economics, 13th edition

 The demand for money

• The amount of wealth that everyone in the

economy wishes to hold in the form of money
balances is called the demand for money

Lipsey & Chrystal: Economics, 13th edition

 Real and nominal money demand

The real demand for money (or the demand

for real money balances) is the nominal
quantity demanded divided by the price
level.

Lipsey & Chrystal: Economics, 13th edition

 Real and nominal money demand

• In our simplified model of the financial system

there are only two assets to choose from:
money and bonds.
• Money pays no interest but bonds do.
• So what you give up by holding money rather
than bonds is the interest yield on those
bonds.

Lipsey & Chrystal: Economics, 13th edition

 Motive for holding money

• Three important services that are provided by

money balances give rise to three motives for
holding money:
– transactionary
– precautionary
– speculative

Lipsey & Chrystal: Economics, 13th edition

 The demand for money and the price
level.

• So far, because we have held the price level

constant, we have identified the determinants
of the demand for real money balances.
• These are real GDP, real wealth, and the
nominal interest rate.

Lipsey & Chrystal: Economics, 13th edition

 • Now suppose that, with the interest rate, real
wealth, and real GDP held constant, the price
level doubles.
• Because the demand for real money
balances will be unchanged, the demand for
nominal balances must double.

Lipsey & Chrystal: Economics, 13th edition

 Note!

• Because the real demand for money

balances is independent of the price level, the
nominal demand varies in direct proportion to
the price level; when the price level doubles,
desired nominal money balances also double.

Lipsey & Chrystal: Economics, 13th edition

 Total demand for money

Lipsey & Chrystal: Economics, 13th edition

 Monetary equilibrium and the interest
rate
• Monetary equilibrium occurs when the
demand for money equals the supply of
money.
• The rate of interest is the relevant price in the
money markets.
• The easiest way to understand how this
works is to start by showing how interest rates
would adjust to clear the money market (i.e.
equate demand and supply) if there was a
fixed money supply.

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition
 Note!

Monetary equilibrium occurs when the rate

of interest is such that the demand to hold
money equals the supply available to be
held, and hence the demand to hold bonds
equals the supply available to be held.

Lipsey & Chrystal: Economics, 13th edition

 Interest rates and monetary policy

• If the Bank wishes to use monetary policy to

exert upwards pressure on the GDP, they can
do so by increasing the money supply.
• If they do this, there will initially be an excess
supply of money.

Lipsey & Chrystal: Economics, 13th edition

 • If they do this, there will initially be an excess
supply of money.
• Holders of this money will demand more
bonds, and via the process discussed above
this will raise the price of bonds and lower the
interest rate.
• This in turn will induce a rise in all interest-
sensitive spending.

Lipsey & Chrystal: Economics, 13th edition

 Note!

In normal times, the central banks in most

industrial countries (or currency zones)
set the interest rate and let the money
stock adjust to demand.

Lipsey & Chrystal: Economics, 13th edition

 The LM curve

• The LM curve shows all of the combinations

of income and interest rate for which the real
demand for money equals the real supply.

Lipsey & Chrystal: Economics, 13th edition

 Note!

The LM curve is positively sloped because a

rise in income increases the quantity of
money demanded (transactions and
precautionary demand) and so must be
accompanied by a rise in the interest rate
that decreases the quantity of money
demanded (speculative demand) by the
same amount if equilibrium is to be
maintained with total quantity demanded
equal to the total supply.

Lipsey & Chrystal: Economics, 13th edition

 Stability of monetary equilibrium

• Suppose that the variables whose equilibria

we are considering, income and interest rate
in this case, depart from their equilibrium
values.
– If forces exist to push them back towards their
equilibrium values, the equilibrium is said to be
stable.
– If forces exist that drive the variables further away,
the equilibrium is said to be unstable.

Lipsey & Chrystal: Economics, 13th edition

 Stability of the LM equilibrium

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition
Lipsey & Chrystal: Economics, 13th edition
 Summary

• As the first step in integrating money into our

theory of the determination of GDP, we have
developed the LM curve.
• This curve shows all those combinations of
GDP and interest rate at which the demand for
money equals its supply.
• The rate of interest is in equilibrium when the
members of the public are content with how
their wealth is divided between these two
assets.

Lipsey & Chrystal: Economics, 13th edition