Economics 330, Handout of December 4, 2006
Quantity Theory of Money Demand
Divide both sides by V
1
M =  PY
V
When the money market is in equilibrium
M = Md
1
Let k 
V
M d  k  PY
Because k is constant, the level of tranactions generated by a
fixed level of PY determines the quantity of M d
The demand for money is not affected by interest rates
Relation of Velocity to Standard
Money Demand equation
Md
 f (i,Y ) where the demand for real money balances is
P
negatively related to the interest rate i,
and positively related to real income Y
Rewriting
P
1

d
f (i,Y )
M
Multiply both sides by Y and replacing M d with M
PY
Y
V

M
f (i,Y )
Equilibrium in the Market for Money:
The LM Curve
• Demand for money called liquidity
preference
• Md/P depends on income (Y) and
interest rates (i)
• Positively related to income
– Raises the level of transactions
– Increases wealth
• Negatively related to interest rates
Equilibrium in the Market for Money:
The LM Curve (cont’d)
• Connects points that satisfy the
equilibrium condition that MD = MS
• For each level of aggregate output, the LM
curve tells us what the interest rate must
be for equilibrium to occur
• The economy tends to move toward points
on the LM curve