LM Curve

[nathan]

I hope someone knowledgeable in economics can answer this question.

 

In the LM curve derivation, demand can be greater or less, but the money supply is a straight unchanging vertical line. The problem is that output is said to increase along with demand, which is later used to plot the lm curve according to the output. But how can output rise according to money demand if money supply does not increase?

 

If supply stays the same and demand goes up, only the price goes up, and the amount sold stays the same. The same will be true for money demand. If the demand goes up but the supply stays the same, the interest rate will rise but the output remains the same. It makes purely logical sense that output gets larger with greater demand along with an increasing supply. The demand and supply of money should thus be a standard X.

[TomRod]

I vote this be moved from the admissions forum to a more proper forum.

[rthunder27]

I'm sorry, but you seem to have some profound misunderstanding of the basic concepts here. Output doesn't rise according to money demand. Money demand is a function of output (along with interest rate), not vice versa. The money supply (in the short term) is a fixed quantity, imagine an economy based on gold, the amount of gold is an independent thing, it can't magically increase, it's completely inelastic and thus a vertical line.

 

The LM curved is derived from the money-market, so that each point on the LM curve represents the money market in equilibrium for a given level of output. So let's look in detail at the money market. Here, the x-axis is quantity of money, and the y axis is interest rate (price of money). The money supply curve is a vertical line because there is a set amount of money in an economy, whether this is the amount produced by a treasury in the case of fiat money, or the total quantity of a precious metal in a metal based economy. The money demand curve (liquidity preference) is downward sloping because the costlier money is, the less of it you want. It is also a function of output, but here's the point I think you missed, a rise in output SHIFTS THE CURVE TO THE RIGHT, it's not just moving along the curve.

 

When you see the downward sloping money demand curve, that whole curve is at one specific level of output. The intersection of these two curves is the money market equilibrium, and would then be a point in the output-interest rate graph, where the x coordinate is the level of output use in calculating the money demand curve, and the y coordinate is the equilibrium interest rate. So if output increases, the money demand curve shifts to the right, and the interest rate increases since money supply is unchanged. So now we take this new equilibrium point and put it in the output-interest rate graph, where the new x and y coordinates are both larger, so this is why the LM curve is upward sloping. I hope that clears things up.

[kipfilet]

Hear hear

[Zeno]

Man, I do not miss undergrad macro.

[TomRod]

Why the downvotes? This is the PhD Admissions forum, after all. Not a forum for homework, for tests, or for help on final papers.

 

If the OP would like a tutoring session, many at this forum are available for such a service. The candidate is free to PM me if he or she would like a session over the IS-LM curve. Otherwise, there is a more proper place for these questions.

Edited May 15, 2011 by TomRod
Clarifying sentitment

[chisquared]

Why the downvotes? This is the PhD Admissions forum, after all. Not a forum for homework, for tests, or for help on final papers.

 

For one thing, there isn't exactly an alternative forum on TM/Urch for this type of question, so I suppose this forum is as good as any. The question being economics-related makes this forum more relevant than any of the others, in fact.

 

Moreover, I think that the forum has grown into a bit more than just helping people with admissions. Of course, this is still the primary role of the forum, but a few topics that are tangentially related here and there can't hurt.

 

Finally, one might even say that this is still somehow related to economics admissions: the OP's understanding of LM curves could be very much related to his decision to go to grad school, which is still related to admissions issues, even if only slightly.

[TomRod]

For one thing, there isn't exactly an alternative forum on TM/Urch for this type of question, so I suppose this forum is as good as any. The question being economics-related makes this forum more relevant than any of the others, in fact.

 

Moreover, I think that the forum has grown into a bit more than just helping people with admissions. Of course, this is still the primary role of the forum, but a few topics that are tangentially related here and there can't hurt.

 

Finally, one might even say that this is still somehow related to economics admissions: the OP's understanding of LM curves could be very much related to his decision to go to grad school, which is still related to admissions issues, even if only slightly.

 

Fair enough. Perhaps, however, there should be a sticky put in place for topic-related questions as an ongoing thread.

[nathan]

Thanks for your answer, rthunder.

 

Let me first say that I am not studying economics in college. This is a pure quest for understanding, not for homework, tests, or finals. I have studied economics on my own, which is why I have limited options when it comes to asking questions. While those outside the "system" generally lack a comprehensive understanding, on the other hand, those outside the "system" often see valid questions where others don't.

 

I do "get" the whole LM thing, I just have one question concerning the vertical line of the money supply (which applies to the derivative of the LM curve, not the LM curve itself).

 

We both agree that a shift of the demand slope to the right represents both a greater demand and a greater output. Which one causes the other is irrelevant (for simple purposes) and can be argued. I have no issue with the demand slope or slopes. My question is about the vertical money supply line (which the demand slope or slopes cross). On most supply and demand graphs, the supply slope is a positive slope (or curve) and not a vertical line. I understand the reasoning behind a vertical money supply line. I just happen to disagree with it. You see, if the output is larger, the supply must be larger. If supply is the same, a larger demand (and shift to the right) does not raise output. A demand shift to the right only raises output when the supply slope is a positive slope. With a vertical supply line, only price (or interest rate) go up, but output (on the x axis) remains the same.

 

I do understand that you can have higher income and output with the same money supply. This means that the velocity of the money supply is greater. Because if money velocity and supply stay the same, you can't have greater output and income. My question, though, is two-fold. First, with our fractional reserve banking, it makes more sense that greater output will translate into a larger money supply, rather than a greater velocity of the same supply. Secondly, it makes little sense to limit the supply curve to just the money supply itself. Money supply and velocity go hand in hand. The way I see it, velocity is supply in another form. Both should be combined into one composite, whereby a greater output reflects a higher supply/velocity. In all, I am saying that the money supply line should not be vertical.

[chisquared]

I think what you're doing is that you're trying to capture several aspects of the money market using only the money supply curve. While that's certainly plausible, it makes it very difficult to find out what caused certain effects in your model.

 

The money supply being vertical just reflects the fact that an exogenous change to the real interest rate should not change the money supply. And it doesn't; in principle, the central bank doesn't have to change the supply of money when the interest rate changes.

 

Moreover, I think the effects on output, et al that you're talking about are already captured by the fact that the LM-curve is upward-sloping.

[nathan]

chisquared (sorry),

 

A higher demand for money and a higher output seem to coincide (irrelevant of which comes first).

Once this is true, either money supply or velocity (or both) must increase when the demand slope shifts to the right (attracting a higher number on the y axis). If you have the same supply of money and the same velocity, how can you have more output?

 

On a logical level, when output and demand is higher (raising the interest rate), more money has to be available to use or the same money has to go around more quickly. The net result, in my estimation, is that the interest rate goes higher, but not as high as it would with the same supply and velocity.

Edited May 16, 2011 by nathan

[chisquared]

I'm not sure who Chris is, but I'm guessing you're replying to my post:

 

First: why does the money supply have to increase? It's not imperative for the central bank to change the money supply in response to economic shocks. I think it's sufficient that the increased velocity of money accounts for the increased output, without the increased supply. While I do agree with you that the velocity of money could be thought of as a type of "supply", it strictly speaking isn't. The money supply is the quantity of money in the economy. Just because money is going around faster doesn't mean that if you freeze all transactions and count all the money that everyone has means that you will end up with a larger number.

 

Second: having a fractional reserve banking system doesn't actually increase the amount of money in the economy. It just helps allocate that money to its most productive uses.

[nathan]

With fractional reserve banking, M1 gets larger once the bank lends out deposited money.

 

Secondly, even if more output is a consequence of only greater velocity, I still feel that this affects the "supply" component. My reasoning is that money is mainly a medium of exchange. The reason the same amount of money can go round and round and achieve greater output is because money is a medium, a means, not an ends. Greater velocity of money is a form of supply of a medium. Whether more money or the same money going around more creates greater output is the same thing. Once you slant the money "supply" slope, a demand shift to the right does not raise the interest rate as highly, and your output is represented on the x axis (where it should be) rather than as a tangent notation on the demand slope.

[chisquared]

With fractional reserve banking, M1 gets larger once the bank lends out deposited money.

 

You're right. But this is a one time thing: as long as the central bank does not change the deposit reserve ratio, then the fact that you have a fractional reserve banking system doesn't increase your money supply. The transition from full reserve to fractional reserve does increase your money supply, but that isn't a transition that happens every day, nor does the central bank decide to change the deposit reserve ratio relatively often.

 

Secondly, even if more output is a consequence of only greater velocity, I still feel that this affects the "supply" component. My reasoning is that money is mainly a medium of exchange. The reason the same amount of money can go round and round and achieve greater output is because money is a medium, a means, not an ends. Greater velocity of money is a form of supply of a medium. Whether more money or the same money going around more creates greater output is the same thing. Once you slant the money "supply" slope, a demand shift to the right does not raise the interest rate as highly, and your output is represented on the x axis (where it should be) rather than as a tangent notation on the demand slope.

 

The upward slope of the LM curve already accounts for the effects of greater velocity on the "supply" of money. You can try to account for that effect on your money supply curve, but I wouldn't recommend it. But really, just because money goes around faster doesn't mean there's more of it.

[rthunder27]

Having the money demand curve shift with changes to output captures the velocity of Money. V*Ms=P*Q . In the short term, P and Ms do not change, and thus velocity and output are proportional, an increase in the amount of transactions requires an increase in velocity. Also note that the velocity of money is very much a derived quantity, its very definition is contingent on the money supply being held constant (short-term). Put another way, velocity is a function of Ms,P and Q, in this framework it is non-nonsensical to have Ms (endogenously) change because of velocity, since this would then make velocity meaningless by construction. At the risk of repeating myself, by definition V cannot impact the money supply, since V is defined in terms of the existing money supply.

 

However, with regard to the effect of fractional reserve banking you're right, the effect is a slight positive slope to the money supply curve in the money market, since an increase in interest rates induces more people to put their cash in the bank, which then expands the money supply. The vertical money supply is just an approximation, since the slope of the money supply curve is very, very high relative to the demand slope. All of these models are approximations that ignore a lot of complications, the relevant questions are always are the ignored complications important, and is it worth complicating the model by including them? In this case I would say no. The impact of including this second order effect by making the Ms curve slightly slanted would be to very slightly change the slope of the LM curve.

 

By all means, always challenge the existing models! But be prepared to have a coherent justification for your ideas, moreso than simply citing "intuition" (ideally one would have data or real life phenomena that one's new and improved model can explain that the old model couldn't).

[dreck]

 

By all means, always challenge the existing models! But be prepared to have a coherent justification for your ideas, moreso than simply citing "intuition" (ideally one would have data or real life phenomena that one's new and improved model can explain that the old model couldn't).

 

I'm pretty sure the ISLM model has been "challenged" pretty well already. Bob Lucas pretty much destroyed it. I'm betting that the fact that the model ignores expectations is much more costly than, say, approximating money supply to be vertical.

[kipfilet]

The consensus is that ISLM is a good undergrad textbook model, but nothing more than that. Its intuitive insights have already been incorporated (and microfounded) in DSGE's through NKMs.

[nathan]

Ideally, one should have real life data to challenge a model. But in an informal setting, the exchange of ideas should be seen as a good thing, which better minds may find useful.

 

To sum up my point, I think the LM curve should end up less steep once the money supply slopes positive instead of being vertical, such that the demand slope crosses it at a lower interest rate.

 

What I am saying is that the velocity of money is another form of money. Instead of having more money, you have the same money with more velocity to accomplish the same thing. As such, the velocity of money applies both to the demand of money and to the supply of money, just like more money applies both to the demand of more money and to the supply of more money.

[OneArmedEcon]

Ideally, one should have real life data to challenge a model. But in an informal setting, the exchange of ideas should be seen as a good thing, which better minds may find useful.

 

An extensive empirical critique of the IS-LM was conducted... in the 1970s and early 1980s. The only time that you'll encounter it as a graduate student in a Top 30 program is if you TA for Intermediate Macro or a take a History of Economic Thought seminar.

[dreck]

An extensive empirical critique of the IS-LM was conducted... in the 1970s and early 1980s. The only time that you'll encounter it as a graduate student in a Top 30 program is if you TA for Intermediate Macro or a take a History of Economic Thought seminar.

 

This. Though what OP is saying about money supply and demand might be applied to modern macro models.

OP: while money velocity is procyclical (source), like you would expect, it just doesn't change the substance of the model, so far as I can see. If you have a reason why variable velocity might change the substantive predictions of the model, I would be interested to hear it. When macroeconomists took down the ISLM model in the 1970s and 1980s, it happened because adding expectations, dynamics, and microfoundations reversed some of the key predictions of the ISLM model, such as the effect of government spending or discretionary monetary policy (which were subsequently rescued by NK models).

 

Edit: Samuelson, too, apparently criticized the assumption of constant velocity: http://en.wikipedia.org/wiki/Velocity_of_money#cite_note-sam_vel-3

But this criticism, which was made in 1948, didn't really catch on, and I'd suspect that it's because it doesn't change much. Also I decided the first paragraph of my first post was crap so I deleted most of it.

[mathemagician]

For one thing, there isn't exactly an alternative forum on TM/Urch for this type of question, so I suppose this forum is as good as any. The question being economics-related makes this forum more relevant than any of the others, in fact.

 

Moreover, I think that the forum has grown into a bit more than just helping people with admissions. Of course, this is still the primary role of the forum, but a few topics that are tangentially related here and there can't hurt.

 

I think most of you are wrong for giving TomRod a hard time. You guys simply weren't here when the forum was inundated with undergrad HW help questions. We had to take a hard stand and not answer their questions for them to go away. If even one undergrad intro micro course from a major university all came to ask questions, this forum would be flooded. Although the OP is not asking a question purely for his classes there is still good reason not to oblige.

 

Be glad that the forum is such a helpful place for graduate admissions because of the hard work of the students that came before you.

[chisquared]

I think most of you are wrong for giving TomRod a hard time. You guys simply weren't here when the forum was inundated with undergrad HW help questions. We had to take a hard stand and not answer their questions for them to go away. If even one undergrad intro micro course from a major university all came to ask questions, this forum would be flooded. Although the OP is not asking a question purely for his classes there is still good reason not to oblige.

 

Be glad that the forum is such a helpful place for graduate admissions because of the hard work of the students that came before you.

 

I think the reason why we normally do not entertain homework questions is not that entertaining them makes this a less helpful place for graduate admissions, but that very often, the kind of help that students ask for usually involves us doing their work for them, which clearly doesn't help them. For instance, I remember one poster who almost definitely copied and pasted his homework questions (around twenty or thirty of them, I believe) verbatim onto this forum, and asked us to answer them. It also probably ruffled some posters' feathers that the homework questions that were posted could easily have been answered by a careful look at any standard economics textbook. I don't think this is quite the case here.

 

As future economists, I think it's our responsibility to try to make the discipline as accessible to anyone and everyone who shows an interest in it. To do otherwise would not only be rather selfish, but would do the discipline a massive disservice: the fewer economically literate "laypeople" there are, the less relevant economics will seem to be to people's everyday lives. This means that it is a good idea to entertain questions like the ones posed by the OP. If this comes at the cost of a greater risk of being swamped with homework questions from undergrads, then that's a price I'm willing to pay.

[MicroMacro]

Although the OP is not asking a question purely for his classes there is still good reason not to oblige.

IMO this forum works so well because it's so tightly focused on admissions and at the end of the day there are numerous other sites where people can ask questions and have discussions regarding economics itself...

[TomRod]

As future economists, I think it's our responsibility to try to make the discipline as accessible to anyone and everyone who shows an interest in it. To do otherwise would not only be rather selfish, but would do the discipline a massive disservice: the fewer economically literate "laypeople" there are, the less relevant economics will seem to be to people's everyday lives. This means that it is a good idea to entertain questions like the ones posed by the OP. If this comes at the cost of a greater risk of being swamped with homework questions from undergrads, then that's a price I'm willing to pay.

 

It's a good idea to never put "By Appointment Only" for your TA office hours: come exam or paper time you'll be completely inundated with students who chose not to prepare or look at available resources. As was noted by many commenting on the subject of the LM curve, this information is freely available with free online texts, Wikipedia, or places like OpenStudy (a great matching service that I highly recommend and involve myself in).

 

It isn't that we mean to be unhelpful. It's just that the marginal cost of continually answering these kinds of questions is much higher in this type of forum than in other arenas (even if they are completely disjoint from URCH properties). The time spent answering these questions dilute the purpose of the forum: namely, congregating concerning admissions. This is not the only place on the internet to discuss economics topics.

[asquare]

We've generally allowed topics related to the study of economics to be posted on this forum. I agree the name of the forum is somewhat misleading at this point, but while there are other places on the internet to discuss economics, there aren't other places on TM. Also, allowing conversation about economics more generally is potentially a way to keep members around after they have matriculated. I'd really like to see a separate or sub forum for discussion of economics topics and of being a graduate student (instead of an applicant), and we've discussed such possible changes. Erin's been swamped and unable to work on that sort of upgrade for a while, though.

 

We don't have a strict anti-homework question policy on TM; instead, we allow that sort of thing to be self-policing. New users learn pretty quickly that their homework questions won't be answered, and unpopular threads fall to the bottom of the forum. Threads like this one, though, have generated some interesting and substantive discussion, and so they remain at the top while at least some people find them worthwhile.

 

When there are other forums on TM that are better-suited for a specific question (like questions about the GRE, or about MBA admissions) or when the questions have nothing to do with economics, we move threads. But for questions that are related to economics or where economics students will clearly have substantially different perspectives than other TM users, this is currently the most appropriate forum. It can be a bit of a hodge-podge, but you can always skip threads you don't want to read. Some people are interested in discussing LM curves; others are interested in the ascendence of the Chinese economy; others are interested in software useful for economics students. If and when a specific type of thread becomes so widespread that it threatens to swamp other discussions, we can look at what if anything can be done. Finally -- we're always open to feedback and to discussing the forums with users, but the feedback forum is really the best place for these sorts of conversations. It's read by a wider range of moderators and prevents forum policy discussions from overwhelming or becoming buried within substantive posts. Thanks.