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