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LM part of the IS-LM model | Macroeconomics | Khan Academy - YouTube
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We've already studied the
IS curve in some detail
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and just a bit of a review here,
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it's just relating real
interest rates to real GDP.
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Let me just write that as Y, real GDP.
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The relationship, there's
2 ways we've viewed it;
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one is real interest
rates driving investment
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which drives real GDP
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or I should say real interest rates
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driving planned investments
which drives real GDP.
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If you have a high real interest rate
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then you're not going to
have as much plan investment
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and if you looked at our Keynesian cross,
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it's pretty clear
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that if you don't have as
high planned investment
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you will not have as high of a GDP
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or high of a real GDP.
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Similarly, if you have a
lower real interest rate
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you'll have more planned investment
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and then you will have a higher real GDP.
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Our IS curve looks like this.
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Our IS curve is downward sloping.
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It's easier for me to draw a dotted line.
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Right over there is our IS curve,
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stands for investment savings curve.
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This right here is taking it much more
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from the investment side,
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how real interest rates drive investment.
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You could also view it
from the other angle.
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You could view how real GDP drives savings
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which drives interest rates.
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That interpretation, at low levels of GDP
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you have less savings.
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That's essentially there
is less excess capital
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to go around and so it is scarce.
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The price of that is expensive
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and the price of money is interest rates
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and if we're dealing in real
terms, real interest rates
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and so it would be high.
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If you have higher GDP
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and everything else is held constant,
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if government spending is held constant,
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consumer spending will go up
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but it won't go up as high as GDP.
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You're going to have more savings,
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there's more stuff to lend around
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and so the price that's
asked for lending that money
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will go down and that price
is real interest rates.
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These are two ways of viewing it.
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This is the savings driven way
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and this is the real interest rates
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driving investment.
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So that's why it's called the IS curve,
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investment savings curve.
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Now, what I want to talk
about is the LM curve, LM.
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Let me draw a little line over here
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although I'm going to
plot it on top of this
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so that we can start thinking
about the equilibrium level
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of real interest rate and real GDP.
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The LM curve, LM stands
for liquidity preference
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money supply.
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Liquidity preference money supply.
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Liquidity preference, it
sounds like a fancy thing
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but it's actually a very basic,
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it's a very basic idea.
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This is, if we hold real money constant
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and when I talk about real money.
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Let me clarify here.
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If I talk about real money,
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we're talking about the
amount of money in supply
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if we adjust for something like inflation.
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You could measure real money,
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in the U.S. you could
measure it as base money
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or maybe the total amount
of federal reserve notes
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or M0.
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You could measure it as
M0 divided by the CPI.
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Maybe M0 goes up
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but if the CPI goes up by the same amount,
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by the same percentage
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then you're not going to
have a change in real money.
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If M0 goes up without prices increasing
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then real money has gone up.
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If M0 stays constant but
prices have increased
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then real money has gone down.
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All liquidity preference is describing is
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if we assume this is constant
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at any given level here,
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assume constant,
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then the more economic
activity that there is
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the more demand that
there is for that money
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and so there will be
higher real interest rates.
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People will be willing to pay
higher prices for that money
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in real terms.
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All it's saying is if you have very,
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let's start over here,
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if you have a lot of economic activity
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people will want to hold currency
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so that they can have transactions
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so they have some flexibility.
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The money itself is going to
be circulating much, much more.
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There's going to be higher
demand for that money.
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If there's higher demand for that money
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people will either be willing to pay more
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for access to that money
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or you're going to have to pay them more
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for them to give you their money
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because they really want that liquidity.
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They really want that
access to their money.
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And the price of money is interest rates.
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For the LM curve, when we think
about liquidity preference,
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holding real money constant,
high levels of GDP,
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a lot of economic activity,
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people want to have currency,
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demand for currency is high
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so the price is currency is high
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which is real interest rates
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and so we would have
real interest rates high
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due to liquidity preference.
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On the other side of that,
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if you have low economic
activity people might say,
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"Well, there's not as
much demand for currency,
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"there's fewer transactions going on."
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And so you will have to pay someone less
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to part with their money
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or if someone's willing to pay less
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in order to get access to money.
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So at low levels of GDP,
according to liquidity preference,
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you're going to have
lower real interest rates.
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Our LM curve looks something like this,
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this is IS in this dotted line yellow
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and our LM curve looks
something like that.
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When you plot these two
constraints against each other
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the IS is telling us a relationship
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between real interest
rates driving investment
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and how that affects GDP
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or how real GDP affects savings
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affecting real interest rates.
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It's a different constraint
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that what liquidity
preference is telling us.
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This is how much people as
things get better and better,
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more and more economic activity,
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people want to hold more money.
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These two different constraints,
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now you take them both into consideration,
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you end up with an equilibrium point.
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There is going to be 1 point
that meets both constraints
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and this is the point at which
the economy is at equilibrium
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Real interest rates and real GDP.
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Now, let's think about what would happen
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if the federal reserve decided to print,
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if we'd take a U.S. focus,
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if the Central Bank or the federal reserve
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decides to print more money?
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By this definition up
here of our real money
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in the very short term,
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especially when we put
our Keynesian hat on,
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we assume in the very short
term prices are sticky.
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This, in the very short term,
this doesn't change much.
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If this goes up then real money goes up
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especially in the short term.
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Real money goes up.
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If real money goes up,
you're essentially increasing
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the supply of real money.
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Anytime you increase
the supply of real money
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at any given level of demand,
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people are going to
want to pay less for it.
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So what you're going to have happening is,
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so at any given level of GDP
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there's now more money there.
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The price of that money
is going to be less,
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the prices of real interest rate.
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If the federal reserve, if
the central bank prints money
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and real money increases,
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we're assuming in the very short term
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that prices don't change
because they're sticky
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so real money has gone up,
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the price of that real money will go down
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at any given level of GDP.
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That would shift the LM curve down
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and so we can start to
see what would that do
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to our equilibrium interest
rates and level of GDP.
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In that situation, real interest rates,
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the equilibrium real interest
rates clearly went down.
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We also see, based on this model,
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some expansion of GDP.
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