Macroeconomics

Chapter 3: Money and LM Curve

Prof. Habermacher
EHL
Chapter objectives/highlights
• Understand the economy’s money, beyond coins & notes

• Different ways how the central bank can control the quantity of money
• Fixing interest rate vs. qty of money

• Simplified “Liquidity Preference-Money Supply curve” aka LM curve

• Describing the monetary market equilibria in the Y vs. i graph

• Myths about how banks create money

• Open discussion - Bitcoin

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Content

1. Functions and types of money

2. Demand for money
3. Supply of money
4. Money market equilibrium
5. LM curve
6. Additional comments

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Functions of money

What do you use money for?

• Buying goods & services

• …?

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Functions of money
Match terms & pictures

1. Medium of exchange

2. Unit of account

3. Store wealth

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Types of money
• One can distinguish different types of “money”
• Distinction mainly according to “liquidity”: how quickly can you get
your cash?

- Physical notes & coins in your pocket (material currency; cash)

⇨ Main function: Means of exchange
LIQUIDITY

-…
- Time deposits – money (in bank accounts) only accessible after
“maturity” date
⇨ Main function: Store value

• We simplify: One single type of money. Main conclusions remain

unchanged
EHL Prof. Habermacher 7

Types of money
Ex. Switzerland:

GDP2020 = CHF 707 bn

Currency (coins+notes)
CHF 90 bn; 12% of GDP

LIQUIDITY
All ‘money’, incl. time-deposits
CHF 1’120 bn; 160% of GDP
Content

1. Functions and types of money

2. Demand for money
3. Supply of money
4. Money market equilibrium
5. LM curve
6. Additional comments

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Money demand
Money demand ≡ Money wanted by the non-banking sector
• Two broad categories of wealth (simplified):
Money Securities (shares, bonds, …)
Can be used for transactions, but does Not used for transactions, but bear a
not bear interest positive interest rate i (return)

• Criteria to allocate wealth between money and financial assets?

What individuals wish to hold in the form of money depends on:
1. Volume of transactions 2. Interest rate of securities (i)
Desire to have sufficient liquidity to The only reason to hold some wealth in
avoid having to sell securities too often securities is to earn interest
to have money
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Money demand
• We assume, on the aggregate level of the economy:
𝑀𝑑 = 𝑌𝑛𝑜𝑚 ⋅ 𝐿( 𝑖 ) ( = 𝑃 ⋅ 𝑌𝑟𝑒𝑎𝑙 ⋅ 𝐿( 𝑖 ) )
− −
Qty of money (nominal) the • Depends negatively on i
population desires to hold (e.g., CHF)
• Proportional to the nominal national
d
income 𝑌𝑛𝑜𝑚
Interest Money demand, M
• Doubles if prices double
rate
• Doubles if amount of goods produced doubles

i Btw, I call i the “opportunity

Md‘ (for revenue Y’ > Y) cost” of holding money!

Md (for revenue Y)
M M’ Quantity of money
Content

1. Functions and types of money

2. Demand for money
3. Supply of money
4. Money market equilibrium
5. LM curve
6. Additional comments

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Money supply option 1

• One natural way for the central bank
(CB) to set the money supply, would be Money supply, Ms
to directly set the amount of money, If CB’s printed a fixed
i.e., to “print” a fixed amount (cash i
amount of money
and/or electronic)
• In a graph with the same Ms vs. i axes Ms
as above, we could then draw money
We will not use this
supply as independent of the interest i representation!
See next slides.

Quantity of money M
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Money supply option 2: Typical case

1 CBs instead tend to set the interest rate,
relevant for commercial banks’ operations Money supply, Ms

Interest
2 ⇨ Commercial banks then ‘create’ money – CB sets a base interest

rate
however much is demanded given that rate rate
– largely on their own

s
• Banks face a cost for creating money: CB’s
1 2 M
i
interest rate i
• Banks pass on this cost to customers
⇨ High CB i means high interest … Quantity of money M
- paid on deposits in accounts
- charged for debt (borrowers) ⇨ We consider this structure of
money supply
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Central bank setting the interest rate

CB’s i strongly impacts other banks’ interests
(annex) – but things are complex: Money supply, Ms

Interest
• Banks’ money creation is subject to many

rate
rules
• Interest rate ‘dimensions’:1
Lending vs. borrowing:
You deposit money in your account: 2% Ms
i
You borrow money (take on debt): 5%
Accessibility/maturity:
Current account = 0%
Savings account = 2%
Fixed-term deposit = 4% Quantity of money M
Risk premium when borrowing: Here: Focus on CB’s interest rate
Family house in Epalinges: 3% (2021: e.g., 1%!) Other interest rates best thought of
Hotel in Antarctica (transport people?): 12% (?) as moving in parallel to that rate
1 Values purely indicative: Examples to illustrate what types of interest rates are higher/lower. Values may be more representative for pre-‘0%-era’
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Central bank setting the interest rate

Good to know: We may refer to CB’s relevant
interest rate as Money supply, Ms

Interest
• Reference (interest) rate

rate
• Base (interest) rate
• Policy rate
• Or simply: interest, interest rate, or i
Ms’= Ms
i
Control question:
• Assume the central bank had set a base
interest rate of 3% per annum
• Assume the economy was in an equilibrium Quantity of
with a money demand of 300 bn CHF money M
• What would happen to the interest rate, if
money demand decreased by 20%?
Money creation – BoE video
As it is a point of great confusions, let’s look at how the Bank of
England explains money creation in a 5 min video:

Note: The video also talks about “Quantitative Easing” and some money creation
myths. We’ll explain these later!

https://www.youtube.com/watch?v=CvRAqR2pAgw

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Content

1. Functions and types of money

2. Demand for money
3. Supply of money
4. Money market equilibrium
5. LM curve
6. Additional comments

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Money market equilibrium
Interest Money market
rate i

i Ms

Md

M* Quantity of
Prof. Habermacher
money M 18
EHL
Impact of a reduction in output
• Recall: 𝑀𝑑 = 𝑌𝑛𝑜𝑚 ⋅ 𝐿( 𝑖 )
−
• Hence: Y ↓  Md ↓
Interest Money market
⇨ Interest rate i unchanged rate i
⇨ Money amount M* reduced: M*’ < M*

Intuitively?
• No surprise: lower demand for money; i Ms
banks reduce money supply as:
↓ Output ⇨ ↓ Need for transactions ⇨ Md (for Y)
Customers want to hold less money at
the given interest rate Md’ (for Y’<Y)
• Interest rate unchanged, as it is directly
set by the CB M*’ M* Quantity of
money M

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Expansionary and Restrictive Monetary Policy

The CB sets the market interest rate, and thereby affects the market money supply:
CB reduces interest from i=3% to i=2%: CB increases interest from i=2% to i=3%:
i ↓ ⇨ L(i) ↑ ⇨ Md ↑ i ↑ ⇨ L(i) ↓ ⇨ Md ↓
Interest Interest

1
i Ms i’ Ms’
1
i' Ms ’ i Ms
Md Md
2

2
M* M*’ M M*’ M* M
Expansionary monetary policy Restrictive monetary policy

Note: This is not all that happens. i affects also Y (How? ⇨ K. cross); we will get
back to this later
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Note on interpreting our monetary model

• Monetary markets & monetary policy are highly complex
• Monetary economists can disagree on the ‘correct’ interpretation of processes in
the monetary market – and, of course, on what good monetary policy is
• We represent CB’s action as that of setting the interest rate relevant for the markets
• This is a good approximation. CB’s reference interest rate is a most crucial policy tool
for the central bank (e.g., Annex: statement by Bank of England)
• Alternative, traditional representation: CBs directly fixing the qty of money
• Which of the two views one adopts, needs not be crucial. Important instead:
(i) CB controls the interest rate & money supply via monetary policy,
(ii) but it cannot choose both independently: their relationship is determined by
the money demand curve, which the CB does not directly control

Our representation, reflecting that CBs typically more directly set the interest, rather
than the amount of money, has the extra benefit of simplifying some of the analysis
Quantitative Easing
Today, central banks regularly use a second tool, intervening in markets very
directly:

“Quantitative Easing”: Purchase of large amounts of financial assets, to

inject money in the economy and lower interest rates on savings & loans
(see also Annex)
Secure assets
Ex. gvmt bonds
Extra money supply
Central bank
↺ Pension fund
⇨ Firms can borrow extra
money at low interest
⇨ Invest

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Content

1. Functions and types of money

2. Demand for money
3. Supply of money
4. Money market equilibrium
5. LM curve
6. Additional comments

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LM curve: Preliminary comment

LM curve ≡ Combinations of i and Y for which the money market is equilibrated

One way to get an intuitive understanding of our LM curve, is by considering what it is not
Alternative money creation

If money supply was restricted (fixed qty Ms): money demand could outstrip supply (⇨
disequilibrium).
This could be prevented if (a) 𝑌 or (b) 𝐿(𝑖) is small, limiting Md (Recall: 𝑀𝑑 = 𝑌𝑛𝑜𝑚 ⋅ 𝐿( 𝑖 )):
−
Either a high interest i, or a low output Y i Alternative LM
curve

⇨ Money mark. in equil. when: high i or low Y LM

⇨ Positive relationship i vs. Y
Y

This is not the situation we consider!

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Horizontal LM curve
LM curve ≡ Combinations of i and Y for which the money market is equilibrated

The money creation method we consider, leads to a different LM curve:

The CB fixes i, and does not fix (restrict) M: The monetary market can
equilibrate for any given level of output Y
⇨ For a given interest rate i, the output Y can take on any value; money supply will not be out
of equilibrium
Here

⇨ Commercial banks will simply create whichever qty of M is demanded

⇨ The LM curve is thus trivial, horizontal: The CB defines i, then lets the i LM curve

banks create the demanded qty of money: the money market ‘auto-
equilibrates’ LM

No need for a special value of Y to enable this Y

• This can be shown graphically (next slide)

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Horizontal LM curve
LM curve ≡ Combinations of i and Y for which the money market is equilibrated

Interest Money market Interest LM curve

rate i rate i
Ms
i LM
𝑀2𝑑 (for Y2 > Y1)
𝑀1𝑑 (for Y1)
𝑀1∗ 𝑀2∗ Qty of money M Y1 Y2 Output Y

“For a given i, is there any Y, for which the money market is disequilibrated?”
No! It always equilibrates!
“Yes, Y does impact the amount of money people want.
But: Banks will simply supply customers with this amount of money, however much it is!
So, no problem (no diesquil.) in terms of money supply M, if Y (or i) changes.”
Content

1. Functions and types of money

2. Demand for money
3. Supply of money
4. Money market equilibrium
5. LM curve
6. Additional comments

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Money creation simplified view 1

“When I bring my money to the bank, the bank has then money that it can
lend to borrowers”?

• Barely reflects how money creation by banks works in reality

• Closer is: If investors like to borrow money, they can do so at the

(commercial) bank. The bank can create money for them.
• Doing so, the bank:
1. Incurs an opportunity cost for the money, related to the CB’s reference interest rate
⇧ Control of money supply
2. Must fulfil some “capital requirements”1
3. Might have to keep a (very!) small amount of money as reserve (e.g., in Europe)
See slides & Bank of England video above
1 Equity (own capita) as a percentage of risk-weighted assets
 Money creation simplified view 2
Client 1 Bank B Client 2 Bank C
CB Lend Lend Lend
100€
Bank A
100€
Get 100€ Store 10%
90€
Get 90€ Store 10%
81€ …
100 € (10€) 90 € (9€)

⇨ “We end up with a 100€ + 90€ + 81€ + … = 100 € ∙ 1/10 = 1000€ of total lending,
based on 100 €. With 1000€/100€ = 10 being the ‘money multiplier’” ?

• Indeed, at least in Europe, CBs tend to require some minimal reserves by the commercial
banks when they lend (create) money
• But: the amounts are very small (1% for ECB, 2.5% SNB), and generally not a binding
constraint (banks tend to hold more reserves anyway)
• Instead: the CB sets a relevant base interest rate. This implies an opportunity cost for
banks when they lend (create) money ⇨ CB uses mainly this interest rate to steer (limit)
the amount of money the commercial banks create. Plus, some more general, risk-
adjusted capital requirements
See previous slide & Bank of England video above
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Note on money supply in the textbook Blanchard
• In the main text, Blanchard considers a central bank that fixes the
quantity of money supplied, rather than the interest rate
• In a Focus note, he mentions the approach corresponding to our
treatment, noting that indeed, modern CBs rather fix the interest
rate, to then let the amount of money created naturally adjust to the
economy’s demand for money given the interest rate, as we do here
• As discussed in the slides above, one may consider this difference
mainly as a nuance in the point of view – although, it does alter the
nature of the LM curve (see above)

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Open discussion - Bitcoin

Traditional currency vs. Crypto:
1. Stable vs. volatile vs. Ponzi scheme?
2. Convenient/low transaction costs?
3. Easy to understand?
4. Transaction transparency?
5. Fixed total amount ⇨ stability?
Mind: total bitcoins vs. total number
of (potential) crypto currencies?!
6. Decentralized/democratic?
7. “Can loose key” vs. “Can loose cash”?!
Mind: Easy to write key on a note bill!?
8. Currency manipulation
2018 9. Anonymity or not at all?
10. Privacy vs. Darkweb/tax fraud/criminality?
11. Hack of wallet?
12. Environment? (right)
Is bitcoin like a race to own a m2 on the moon – or of a
random faraway star we can never reach – or of an
imaginary star, with any ‘fundamental’ reason for
anyone to care about that particular one? ⇨ Concept of
“Focal point”
End

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Annex

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 Pass-through of CB’s base interest rate I/II
Australia The 'gvmt bond yields' are an
indicator of the 'risk-free' (≈) interest
rates of the economy, if a gvmt has no
significant risk of going bankrupt!

Here, we see that this interest rate

follows almost perfectly the key rate
of the CB (Reserve Bank of Australia)

Interesting: The 2-year bonds

anticipate (!) the movements of the
• AUS gvmt 2-year bond yield = yield (interest rate) when you policy rate of the RBA. This makes
lend money to the AUS gvmt for 2 years sense: If you buy a 2-year bond, your
• RBA cash interest rate target: Reference interest of the AUS money is fixed for 2 years
CB, «RBA», for commercial banks
Source: https://vgbgroup.com.au/market-updates/chart-of-the-week-australias-
waiting-game-on-interest-rates (as of 21.3.2022)
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Pass-through of CB’s base interest rate II/II
Source: Illes & al. 2015 “Why did bank lending
rates diverge from policy rates after the financial
crisis” https://www.bis.org/publ/work486.pdf

Note: The authors explain: the

apparent divergence up to 2015 (right
sides of the graphs), does not mean
pass-through from CB to commercial
bank interest rates has declined;
instead, there are separate factors
that have made the difference larger
(e.g., higher risks premia in the
economy)

Policy rate = CB’s interest rate

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Simple statement: means & purpose by Bank of England
What is monetary policy?
Monetary policy is action that a country's central bank or government can take to influence how
much money is in the economy and how much it costs to borrow. As the UK’s central bank, we use
two main monetary policy tools. First, we set the interest rate that we charge banks to borrow
money from us – this is Bank Rate.
Second, we can buy bonds to lower the interest rates on savings and loans through quantitative
easing (QE).

What we use monetary policy for

Monetary policy affects how much prices are rising – called the rate of inflation. We set monetary
policy to achieve the Government’s target of keeping inflation at 2%.
Low and stable inflation is good for the UK’s economy and it is our main monetary policy aim.
We also support the Government’s other economic aims for growth and employment. Sometimes,
in the short term, we need to balance our target of low inflation with supporting economic growth
and jobs.

Source: https://www.bankofengland.co.uk/monetary-policy (as of 6 Feb 2022)

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Grumpy Economist Blog
Enjoyable read about all that is – according to him – wrong with the US central bank and so
many other things in our macroeconomy! Often strongly related to topics we consider!
The Grumpy Economist

https://johnhcochrane.blogspot.com/

The author is Fellow of the Hoover Institution, a conservative think-tank that promotes
“personal and economic liberty, free enterprise, and limited government” (Wikipedia). Does
this mean he must be biased? Either way, his weekly or so email newsletter a surprisingly
interesting read for probably both, conservatives and non-conservatives!

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Example money demand Example:

Interest i L(i) Md Md
If Y = 100 bn CNY If Y = 200 bn CNY
0% 0.6 60 bnCNY 120 bnCNY
1% 0.4 40 bnCNY 80 bnCNY
2% 0.25 25 bnCNY 50 bnCNY
3% 0.15 15 bnCNY 30 bnCNY
4% 0.10 10 bnCNY 20 bnCNY

4% 4%
L(i)

Interest rate i
3%

Interest rate i
3%
If Y = 100 bn CNY
2% 2%
If Y = 200 bn CNY
1% 1%
0% 0%
Return: 0 0.2 0.4 0.6 0.8 0 20 40 60 80 100 120 140
Liquid. Preference L
Qty of money M [bn CNY]
Money demand - check your understanding
Wooclap
Which 2 statements are correct?

A. The higher the interest rate, the more money people hold: All
money we hold, yields interest.

B. The higher the interest rate, the less money we hold: With
‘money’ we mean the most liquid wealth (coins, notes, current
accounts) with often zero interest. This is opposed to securities www.wooclap.com/HABMACEN
(shares, bonds…), which we only hold because they yield interest.

C. The more things we buy (Y..), the more money we tend to hold;
it’s about convenience!

D. Higher GDP means lower money demand.

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