The nominal interest rate on m

The nominal interest rate on money increases

·Money demand increases.

·Individuals sell non-monetaryassets

·Prices of non-monetary assets fallsand returns increase

·The LM curve shifts up as interestrates are higher with output held constant.

I am confused with thestatements above. why nominal interest rate increase, demand formoney increase. this is contradict with the theory in financialmarket: higher interest rate, lower demand for money?can someone explain?


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The LMCurve

The Asset MarketEquilibrium

Remember that:

M – Money supply which is policydetermined

MD – Money Demand

MD = P L(Y,r+πe)

MD/P = L(Y,r+πe)

Money demand is determinedby:

1.  The price level(proportionally)

2.  Real income

3.  Real interest rate

4.  Expected inflation

5.  Nominal interest rates (i=r+πe)

6.  Wealth

7.  Risk

8.  Liquidity (of non-monetaryassets)

9.  Payment technologies

The relationship between MD and Yis determined by the income elasticity of demand:

ηy = %ΔMD /%ΔY

Or the percentage change in moneydemand resulting from a one percent change in realincome.


Which means that money demandincreases less than proportionally with increases inincome.

Incidentally (nominal) interestelasticity of demand is:

ηi = %ΔMD /%Δr


ηi < 0

A 1% increase in interest rateswill result in a decrease in money demand.

Deriving the LMcurve:

·When Yincreases real money demand increases – i.e. the demand curve formoney shifts up and to the right.

·If thereal interest rate did not change money demand would exceed moneysupplied.

·Excessfor money forces individuals to sell-off their non-money assets(such as bonds). **

·Theprice of bonds decreases as the supply of bonds on the asset marketincreases.

·As theprice of bonds is inversely related to their rate of return thenominal interest rate increases.

·Withinflation held constant an increase in the nominal interest ratetranslates into an increase in the real interest rate.

·Interestrates increase until the asset market is in equilibrium.

The LM curve maps out the level ofthe real interest with t he corresponding level of real income (Y)when the asset market is in equilibrium.

** remember that (Md –M)+(NMd-NM)=0

The LM curve is upward sloping asincreases in Y (on the x-axis) lead to increases in money demandand increases in the interest rate need to clear the assetmarket.

FactorsThat Shift the LM Curve:

Anything the changes theequilibrium in the asset market (with output held constant) willshift the LM curve.


The Bank of Canada increases themoney supply (using open market operations)

·The Mcurve shifts right.

·M >MD so individuals try to buy non-monetary assets to ride themselvesof excess money holdings.

·Theprice of non-monetary assets increase

·Interestrates fall with output held constant.

·The LMcurve shifts down and to the right.

The nominal interest rate on moneyincreases

·Moneydemand increases.

·Individuals sell non-monetary assets

·Pricesof non-monetary assets falls and returns increase

·The LMcurve shifts up as interest rates are higher with output heldconstant.

One more thing we need to knowbefore we discuss the equilibium in the IS/LM – FEmodel:

How does the asset marketequilibrium affect the price level (P)?

In equilibrium:

MD/P = L(Y,i) = M/P


P = M / L(Y,I)

Which says that the price level isequal to the ratio of real money supply to the real demand formoney.

If we want to know about inflation( π = ΔP/P ) we rearrange the terms in the equation above andget:

π = Δ M / M – Δ L(Y,i) /L(Y,i)

(see the appendix A-7 for extrahelp on growth rates)


π = ΔM / M – ηy ΔY /Y


Suppose that the money supply isconstant (ΔM / M=0), that real income is growing at 3% per year andthe income elasticity of money demand is .6. Inflation willbe  equal to – 1.8%.

Consider the effects on theequilibrium position of the IS/LM model of:

A temporary adverse supply shock(labour market adjusts)

A future adverse supply shock(Goods market adjusts)


1.  If the IS/LM model is not inequilibrium assume that the goods market and the asset market is inequilibrium and that the labour market is not (labour marketsadjust the slowest while asset markets are quick toadust)

2.  If aggregate demand increases firmsare willing to increase output (aggregate) temporarily.

Two examples from MacroPolicy:

Fiscal policy:

What happened to the equilibriumwhen there is an increase in Government Spending?

1.  The savings curve shifts up and tothe left as individuals reduce savings, and consumption.

2.  The interest rate that clears thegoods market increases as firms compete for the supply ofsavings.

3.  The IS curve shifts up and to theright, as interest rates are now higher at every level ofoutput.

4.  The short term equilibrium is now atthe point where LM intersects with IS and output is above thefull-employment level.

5.  Aggregate demand for goods is nowgreater than the aggregate (long term) supply, firms increaseoutput and begin to increase prices.

6.  The LM curve shifts up and to theleft as prices increase until the LM curve intersects the FE curveat the same point as the IS curve.

Monetary Expansion:

1.  The central bank uses expansionarymonetary policy, increases the money supply.

2.  The LM curve shifts down and to theright, as discussed earlier.

3.  Aggregate demand for goods is nowgreater than the aggregate (long term) supply, firms increaseoutput and begin to increase prices.

4.  The LM curve shifts up and to theleft as prices increase until the LM curve intersects the FE curveat the same point as the IS curve.

The aboveeffects will be same for a one time increase in the money supplyand for any increase in the money supply which is greater than thetrend in inflation.

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