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Some thoughts on the interest rate of ISLM model
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Looking up at the Starry Sky
There has always been a puzzle when learning the ISLM model. What are the interest rates in IS model and LM model respectively? I looked it up on the internet, and it seems that no one has paid attention to this problem. So I carefully looked up Man Kun's explanation of loanable funds market in Principles of Economics, and guessed that I could get the answer with the help of loanable funds theory.
First, according to Man Kun's theory, the interest rate in the loanable funds model is the nominal interest rate. From God's point of view, it seems more appropriate to interpret it as the real interest rate, because even if the nominal interest rate is high, if there is a high inflation rate, then people's willingness to supply loanable funds will not be too high. But the prerequisite here is that people can accurately predict the changing trend of inflation rate, which is very difficult in reality. So in most cases, the standard that people can refer to is the nominal interest rate.
Secondly, I want to explain the relationship between the money market and the loanable funds market. Of course, the money market cannot be directly equated with the loanable funds market: the money supplier is the central bank, which is fixed in the LM model; Loanable funds's suppliers are depositors, and the amount of money they are willing to lend is affected by the nominal interest rate. However, there is still a connection between the two. My understanding is that LM model studies people's preference for money, that is, how much money they are willing to hold. According to Keynes's theory, marketable securities are the only substitute for money. In other words, people either want to hold money or give it up to buy securities. The theory of loanable funds can be regarded as the balance between supply and demand of securities: the supplier of funds lends funds to the demander with securities as evidence. Therefore, the higher people's demand for money in LM model means that people are unwilling to lend money to securities in loanable funds theory. In the theory of loanable funds, the lower the interest rate, the less willing people are to provide loanable funds. When people turn to LM mode, the greater the demand for money. Obviously, this conclusion is completely in line with the changing trend of the money demand curve. Then, since the interest rate in the theory of loanable funds is a nominal interest rate, we can think that the interest rate in LM model is also a nominal interest rate.
In fact, we can get the answer from another angle. LM model assumes that the real money supply M/P remains unchanged, and both m and p remain unchanged. Since the price level has not changed, it means that there is no inflation rate. At this time, the nominal interest rate and the real interest rate are equal, and there is no need to distinguish. From this point of view, the simple paragraph above seems to be nonsense. But at least the above demonstrates the connection between the two markets, which is useful if there is no mistake.
Then we will look at the IS model. IS model focuses on commodity market, that is, the impact of interest rate on investment. According to my understanding, the premise of investment is to borrow from loanable funds, so the interest rate that affects loanable funds and the interest rate that affects investment can be expressed by the same interest rate, so the interest rate here can also be regarded as the nominal interest rate. However, it IS said that the interest rate in the IS model is the real interest rate, but the model studies short-term economic changes, so the real interest rate and the nominal interest rate can be regarded as equal here. I'm still confused about this place.
Finally, let me talk about my understanding of the liquidity trap based on the above conclusions. When the nominal interest rate is particularly low, the price of securities in the market becomes very high. At this time, people think that the interest rate can't be lower, and it will bottom out soon, and the stock price will fall. So people will sell securities crazily at this time, and the demand for money is often endless. Then, even if the central bank increases the real money supply, the nominal interest rate will not be further reduced, which means that monetary policy has lost its effectiveness.
Edited on March 23rd, 2020. The copyright belongs to the author.
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