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In deriving the LM curve, we assumed that money demand was negatively related to the interest...

In deriving the LM curve, we assumed that money demand was negatively related to the interest rate. Suppose instead that money demand depends only on the real value of transactions, Y . Draw the money demand curve for this case. What does the LM curve look like if money demand has this property? Explain. (Note: If money demand is independent of the interest rate, then we have the quantity theory of money.

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Answer #1

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Ans:

General form of money demand:

Md = kY - hi

where,

Y = real output

i = interest rate

k, h are constant parameters.

When money demand is independent of interest rate (i), we have:

Md = kY

Money market equilibrium (LM curve):

Money supply = Money demand

M = kPY (LM curve)

This corresponds to quantity theory of money:

M/k = PY

Since, both money supply and demand are independent of interest rate, LM curve is also vertical.

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Have a nice day ahead!

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