Page 175 - DECO402_Macro Economics

Macroeconomic Theory

Notes The balanced interest rate (Or) is determined on a fixed
demand of money (L) and supply of money (M) on that
point where L = M.
The demand rises with the rise in GDP, consequently
the demand of money curve becomes L on being
2
shifted from L . Consequently the interest rate
1
becomes Or on incresing from Or. Similarly, if there
1
is reduction in GDP, then there will also reduction in
demand of money, because of which the demand of
money curve bacomes L on being shifted backward
3
from L . Consequently, the interest rate becomes Or
1
2
on decreasing from Or. So the change in GDP, becomes
the cause of change in interest rate by the change in
demand of money.
Here the considerable thing is that the impact of change Figure 18.8
in GDP occurs only on the transaction demand of money not on speculative demand of money. We
know that there is no any direct relationship between transaction demand of money and ‘r’; then
why is ‘r’ being affected from the change in GDP? The fact for this is so: when transaction demand
of money rises (because of rise in GDP) then when does the money come from? Because it is our
recognition that supply of money remains constant (as shown in the vertical straight line in the figure).
The pressure of transaction demand of money makes a pressure on speculative investment of money.
To fulfil the increasing transaction demand people sell their assets/bonds. The rise in sale of bonds
falls their prices, the interest rate rises accordingly. So rise in GDP - rise in the demand of money for
transaction - the pressure of selling assets/bonds, so that the cash balances could be increased for
transaction purpose – fall in price of bonds – rise in interest rate.

(II) Relationship between different levels of r and GDP on the one hand
and equality between L and M on the other: LM Curve

Because there become a change in demand of money and interest rate because of change in GDP, for
each level of GDP the interest rate should be such which bring the equality in demand of money and
supply of money, on considering that price level and wealth level remain constant. On joining the
different combinations of interest rate and actual GDP, we get the LM Curve. Figure 18.9 shows the
derivation/getting of LM Curve from money market balance.

Figure 18.9

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