Macro economics, monetary economics

1. THE LM CURVE
Prof. Prabha Panth,
Osmania University,
Hyderabad
05/05/2016 1Prabha Panth

2. 2
LM curve
• Based on Keynesian theory of Liquidity
preference.
• It shows equilibrium in Money Market.
• Demand for money includes:
• Transaction/Precautionary demand TPr = f(Y)
• Speculative demand for money Sp = f(i)
MD = L(Y, i)
• With different levels of Y, there will be
different levels of D for Money.
05/05/2016 Prabha Panth

3. 3
LM curve
• The Supply of Money is fixed by the
Central Bank.
• The intersection of the DM (Liquidity
preference) and SM gives the rate of
interest.
• If NY increases, DM also increases, and
the LP curve shifts upwards.
• This causes i to increase.
05/05/2016 Prabha Panth

4. 4
Derivation of LM curve
Rateof
interest
Rateof
interest
0
0Money NY Level
MS
MD(Y0)
i0
MD(Y1)
i1
MD(Y2)
i2
i0
Y0
i1
Y1
i2
Y2
LM

5. 5
LM curve
• The LM curve relates different levels of NY with
different rates of interest.
• The rates of interest change, when the demand
for money changes with change in NY.
• As NY increases, DM for transaction increase.
• So, given SM, i has increases, with increases in
DM
• Therefore there is a positive relationship
between rate of interest and levels of NY.
05/05/2016 Prabha Panth

6. 6
Slope of LM curve
• The LM curve slopes upwards to the
right.
• It shows that i increases with NY.
• The slope of the LM curve depends
on:
a) Elasticity of DM with respect to Y.
b) Elasticity of DM with respect to i.
05/05/2016 Prabha Panth

7. 7
Shifts in LM curve
• The LM curve’s position is determined
by:
a) Money supply: if money supply
increases, then the LM curve will shift
to the right.
b) Liquidity preference: if there is more
SP demand for money, then LM curve
will shift to the left.
Because level of NY does not affect
LP.
05/05/2016 Prabha Panth

8. 8
Features of LM curve
1. LM curve shows the combinations of i and
level of Y, when Money Market is in
equilibrium.
2. It slopes upwards to the right.
3. LM curve is flatter if DM is i elastic, and
steeper when it is inelastic
4. It shifts to the right when MS increases,
and to the left when MS decreases.
5. It shifts to the left if there is increase in DM,
and to the right when there is decrease in
DM, at given rate of interest.
05/05/2016 Prabha Panth