Model Answer
0 min readIntroduction
The Liquidity Preference-Money Supply (LM) curve, a cornerstone of the IS-LM model developed by John Hicks and Alvin Hansen, illustrates the relationship between interest rates and the quantity of money demanded. It represents combinations of interest rates and income levels where the money market is in equilibrium. The slope of the LM curve is crucial in determining the effectiveness of monetary policy. Classical and Keynesian economists hold fundamentally different views on the factors influencing this slope, stemming from their contrasting assumptions about how individuals and the economy respond to changes in the money supply. This answer will delineate these assumptions and their implications for the LM curve’s slope.
Keynesian Extreme Monetary Assumptions and the LM Curve
Keynesian economics, born out of the Great Depression, posits that the economy can be stuck in a prolonged period of insufficient aggregate demand. Keynesian assumptions regarding monetary policy are:
- Sticky Prices and Wages: Prices and wages are assumed to be ‘sticky’ downwards, meaning they don’t adjust quickly to changes in demand. This implies that monetary policy changes primarily affect real interest rates, not prices, in the short run.
- Interest Rate Sensitivity: Demand for money is highly sensitive to changes in the interest rate (high elasticity). This is due to the speculative demand for money – people hold money expecting interest rates to rise, reducing bond demand.
- Stable Velocity of Money: While not strictly ‘stable’ in the short run, Keynesians acknowledge that velocity doesn’t change dramatically with small changes in income or interest rates.
These assumptions lead to a flat LM curve. A small change in the money supply results in a relatively large decrease in the interest rate, as the demand for money is highly responsive. The flat slope indicates that monetary policy is quite effective in stimulating aggregate demand, as lower interest rates encourage investment.
Classical Extreme Monetary Assumptions and the LM Curve
Classical economics, predating Keynes, assumes a self-regulating economy that tends towards full employment. Classical assumptions regarding monetary policy are:
- Flexible Prices and Wages: Prices and wages adjust quickly and completely to changes in demand and supply. Any increase in the money supply is immediately reflected in higher prices, leaving real variables (like real interest rates) unchanged.
- Low Interest Rate Sensitivity: Demand for money is relatively insensitive to changes in the interest rate (low elasticity). People primarily hold money for transaction purposes, and changes in interest rates have a limited impact on their money holdings.
- Constant Velocity of Money: The velocity of money is assumed to be constant or at least highly predictable. Changes in the money supply directly translate into proportional changes in the price level (Quantity Theory of Money).
These assumptions result in a vertical LM curve. An increase in the money supply leads to a proportional increase in the price level, but has no effect on the real interest rate or output. The vertical slope signifies that monetary policy is ineffective in influencing real economic activity; it only causes inflation.
Comparative Table
| Feature | Keynesian | Classical |
|---|---|---|
| Price & Wage Flexibility | Sticky | Flexible |
| Interest Rate Sensitivity of Money Demand | High | Low |
| Velocity of Money | Relatively Stable | Constant |
| LM Curve Slope | Flat | Vertical |
| Monetary Policy Effectiveness | Effective | Ineffective |
Real-World Relevance and Synthesis
In reality, neither extreme holds perfectly. Modern economies exhibit characteristics of both schools of thought. In the short run, prices and wages are often sticky, giving monetary policy some effectiveness (supporting the Keynesian view). However, in the long run, prices and wages tend to adjust, diminishing the impact of monetary policy on real variables (supporting the Classical view). The slope of the LM curve, therefore, is likely to be somewhere between perfectly flat and perfectly vertical, depending on the time horizon and the specific economic conditions.
Conclusion
In conclusion, the contrasting assumptions of Keynesian and Classical economics regarding price flexibility, interest rate sensitivity, and velocity of money lead to drastically different implications for the slope of the LM curve. A flat LM curve, characteristic of the Keynesian model, suggests effective monetary policy, while a vertical LM curve, typical of the Classical model, indicates monetary policy neutrality. Understanding these differences is crucial for analyzing the potential impact of monetary policy interventions in various economic scenarios. Modern macroeconomic thought recognizes the limitations of both extremes and emphasizes a nuanced approach that considers both short-run and long-run effects.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.