Hi! Please correct my understanding below. IS curve states that as real interest rate decreases, money held for consumption increases. Demand for money is desire to hold interest bearing assets. LM curve states that as real interest rate decreases, money invested in money market decreases. What do you mean by real income in the goods market? What about real income consistent with equilibrium in the money market? In real money supply formula (M/P), what does price level refer to?
Explanations for:
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Correct, if real interest rates are low, savings will decrease in favor of higher consumption levels.
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False, demand for money is all the way around, it is money held for consumption. Interest bearing assests can be investments or savings (almost indistinguishable).
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Correct, LM curve states that for higher real interest rates individuals are less willing to hold real money in their balances, so in other words they do not want money, therefore they increase their savings or invest more in money markets. For your question of a decrease in real interest rates, indeed it decreases the money invested in money markets.
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Real income is production level, also known as Real GDP (Nominal GDP deflated) so it is a measure of how much production (number of units produced) has grown. So real income is an indicator of economic development. Nominal income ($) may not reflect the real economic development because price levels distort the real production level.
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IS-LM model states this, the real variables are acompanied with nominal variables. To be more clear, income and savings and money are interrelated, you can see this at points 2) and 3)
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Money is a nominal variable, so M/P is a real variable. M/P is Money / Price level, or CPI. For example, If you have 50 dollars and a soda is 10 dollars you can buy 5 sodas. What happen if the soda goes to 12.5 dollars? Correct, I can buy only 4 sodas now. This is known as real money (what can I buy with my money).
Any questions please ask.
Regards
Just a clarification in point 2).
I meant investments and savings are almost indistinguishable for very low-risk and short-term investments.
Given what you said about demand for money, I guess supply for money is the opposite, the money in the money markets.
I see. So that means real money supply is the quantity of x which a certain amount of money can buy.
As for this, I don’t get its relation to my question- what about real income consistent with the equilibrium in the money market. You mentioned that real income is production level. Is production level, the real income consistent with the goods market as well as the money market?
My comments for each part:
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Money supply is given exclusively by the central bank of each country. The money supplied goes to every single market of the economy, not only the money market. I think you are confused about what money market is. If it is the case, I tell you that money markets are very-low-risk short-term investments, like repos, comercial papers, certificates of deposit or t-bills for example (there are much more). Definition of money is a large explanation, look for some books about it, they talk about the M0, M1, M2, etc, which are money supply by liquidity.
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Exactly, the real money (M/P) for a given amount of money (M) in an economy can vary due changes in the prices of goods and services §. For economists, real money is the variable to analize, not only money per se.
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In a simple manner, the model of IS-LM states that goods market and the money market (this is the global sense of money, demand and supply of coins) must be in equilibrium at the same time, each one of course. The first one gives an equilibrium of real interest rates and real income, and the other one, an equilibrium between demand and supply of money that affects the real interest rates, therefore the real income market (the good market), do you get now the relation between both?. So, the central banks around the world has at least two ways to affect the real variables (production level for example) changing nominal variables (like money supply or nominal interest rates, the prime rate for example). Thats why when you hear about a recession the FED for example repurchase bonds emmited in previous years with the intention to supply more Money to the economy, this extra money reduces the interest rates of the overall economy making more cheaper the present consumption and investment so this enchance production levels and the GDP grows (the real one of course). The other way is to directly change the prime rate of the central bank which will consequently change the other market interest rates and the effect is the same as the previous case.
Any questions please ask,
Regards
I appreciate your effort, but I’m not sure I get it. I understand that the FED is using QE to increase money supply, lower interest rate, pump up spending and therefore, stimulate US economy. I understand that IS curve: LM curve: real interest rate: real income in the goods market: real income in the money market is to Demand curve: Supply curve: price: quantity demand: quantity supplied. I think what bothers me are the terms real income in the goods market and real income in the money market. You mentioned that real income in the goods market is GDP. Is real income in the money market GDP? If not, what is it?
Look, there are two markets, the real market and the nominal market.
The real market is the market of quantity of goods and services produced at each moment of time (say a year). Real interest rates affect the quantity of goods produced (Q of goods produced is also known as real GDP, aggregate demand, real income, production level, you choose), so at any moment in time, there is an equilibrium between real income and real interest rates, say for example, when real income is USD 50,000 the associated real interest rate of the economy is 7%, or when the rate is 8%, real income is USD 43,000. But, the question here is, what is the dependent and the independent variable? The real income is the dependent and real interest rates are the independent in this case. Why? Because the real rates comes from the market of demand and supply of money.
Now, the nominal market , the money market here is the market where the equilibrium of demand and supply of money gives as a result a given nominal interest rate for the entire economy (actually are many rates, but simplifying). So, that nominal rate deflated gives you the real interest rate (the same used above in the real market).
That is the whole relation between both markets, if you see carefully, the equilibrium of both markets are related, for every equilibrium in the money market you have an equilibrium in the real market and viceversa (like a cycle with no end, thats why the central banks act on the money and nominal rates to influence the real market).
Just get that in mind and you can understand the mechanics of the IS-LM model. Personally speaking the IS-LM model is a good model, but not perfect to explain everything.
Coming back the Quantitative Easing (QE). This is in fact the repurchase of national bonds previously emmited by the central goverment with the intention to expand the quantitiy of money available in the economy. The prices of this bonds increase so the interest rates decrease (from the short to the long-term rates), so lower interest rates increases consumption and investment and therefore an increase in real GDP.
Any questions please ask.
Regards
Hi!
Thanks! I guess I understand the IS-LM curve, in that, at least, I finished the reading which covered it and didn’t have any problem with the topics that followed.
Just to be clear, my understanding of QE in relation to the topic is complete right? I vaguely describe the QE relative to your description of it,but still sufficient in that I hit those which are relevant to QE. Thanks again
What you said about the QE is right. Remember this is an expansionary monetary policy so keep this definition clear for the exam.
Good Luck!
The recent events in US have been supplementary to the business cycles and monetary policy portion of the curriculum. It was enjoyable to have an improved understanding on the things happening. Thanks a lot!