Full Derivation & Summary of the IS-LM Model with Policy Applications

Economics Principles of Economics Nikhil Patel


IS-LM Model
Money Functions:
 Unit of Account
 Medium of Exchange
 Leads to the Transactionary Demand for Money: The money needed
to cover routine expenditures.
 Store of Value
 Storing wealth that is not used in the Transactionary demand for
money.
 Standard of Deferred Payment

Consumption & Money:
 Consumption = Flow Variable
 Money = Stock Variable


The Quantity Theory of Money:
 The Quantity Equation is as follows:
 Money Supply x Velocity of Circulation = Price Level x Real Income
MxV=PxY
 P x Y is known as Nominal Income.
 The quantity theory of money states that the velocity of circulation is fairly
constant throughout.
 In this case, it means that if the money supply grows faster than real
income, then the price level will increase.
 This is the concept behind Inflation.


Transactionary Demand for Money:
 Shoe-leather costs are the costs (time, money, etc), that occur through the
cause of interest rates.
 The DEMAND FOR MONEY will rise when the INTEREST RATE falls.
 This gives us the Transactionary money demand function, as follows:

L = kY – hi

 LD = Demand for Money/Liquidity
 Y = Income
 k = Positive Constant
 h=
 i = Interest Rate

EXPLANATION:

, Economics Principles of Economics Nikhil Patel

 Income (Y) works positively with the Transactionary demand for money,
because if people’s incomes increase, then their level of consumption will
also increase.
 This leads to the need for more money to be held in supply.
 Interest Rate works negatively with Transactionary demand for money,
because as interest rates rise, the benefit of storing money in accounts
increases.


Store of Value:
 Money that is not used for consumption (non-Transactionary demand for
money), must be saved/stored in way that will generate a return.
 Money as an asset is inferior to other forms of assets as it fails to
generate a return.
 However not all this excess can be saved, as Transactionary demand for
money only covers planned expenditure.
 In reality, money must be set aside for unexpected spending such as
accidents.
 Thus, individuals will keep aside liquid wealth/money for these cases.
 This leads to our other form of demand for money:

Precautionary Demand for Money:
 The wealth held in the form of money/liquid, for the purpose of covering
unexpected expenditures.
 As explained above, the precautionary money is the spare money that is kept
aside for unplanned emergencies of any kind.

Speculative Demand for Money:
 However precautionary demand for money can also arise from the distrust in
the financial institutions that hold money, or just the lack of trust of holding
money in other asset forms altogether.
 For example, Stock Market Crashes show how keeping money in
assets of that form, can be risky.
 In these cases, money may be preferred to be kept as liquid until the
prospects of other assets improve and become more convincing.
 This leads to the Speculative Demand for Money:
 Wealth held as money at times when other assets are too risky.
 During normal economical periods, this form of demand for money is muted
and insignificant. But during recessions and crises, it becomes critical.




Money Supply: