ABSTRACT
This chapter describes money and bonds, and explains the portfolio choice that households make in allocating their wealth between money and bonds. The existing theories of the demand for money conclude that the portfolio decision depends on two variables, income and the interest rate. The chapter derives the liquidity-money (LM) curve under the supposition that the real money supply was constant because the monetary authority had determined the money supply and because prices are constant by assumption. An increase in the money supply shifts the vertical supply of money to the right. Each level of Gross Domestic Product (GDP) will be associated with a lower equilibrium interest rate than before the money supply increased. An expansionary monetary policy shifts the LM curve to the right. The chapter assumes that for all practical purposes the economy achieves asset market equilibrium instantaneously.
