Consider the money market to better understand the horizontal LM curve in this chapter.

The money market relation (equation 5.3) is \(\frac{M}{P}=Y L(i)\)

Equation 5.3

a. What is on the left-hand side of equation (5.3)?

b. What is on the right-hand side of equation (5.3)?

c. Go back to Figure 4-3 in the previous chapter. How is the function \(L\) (i) represented in that figure?

d. You need to modify Figure 4-3 to represent equation (5.3) in two ways. How does the horizontal axis have to be relabeled? What is the variable that now shifts the money demand function? Draw a modified Figure 4-3 with the appropriate labels.

Figure 4-3

e. Use your modified Figure 4-3 to show that (1) as output rises, to keep the interest rate constant, the central bank must increase the real money supply; (2) as output falls, to keep the interest rate constant, the central bank must decrease the real money supply.

Transcribed Image Text:

M P Y L(i) (5.3)