TERM 1- Credits 3 (Core)

Prof Madhu & Prof Rajasulochana

TAPMI, Manipal
Session 11

The Money market equilibrium: LM curve

The LM curve shows all the combinations of interest rate (i) and output
(Y) such that money demand equals money supply.
Derived in two steps:
1. Explain why money demand depends on interest rates and income
2. Equate Money demand with money supply

2 Theories on Money Demand

Theory 1: Quantity Theory of Money

QTM:
MV = PY
M = Money Supply, V = Velocity of Money, P = Price Level, Y = Output
Inflation is always and everywhere a monetary phenomenon. - Milton Friedman

Holding V as constant, real money supply is:

( ) = ( )Y = ( )

Rewriting, ( ) = k.Y
where k =

k is constant, denotes proportion of income people hold as cash

The level of transactions generated by a fixed level of PY(nominal output ) determines the demand
for real money.

i.e ( )

Theory 2: Liquidity Preference Theory

1) Transactions demand - to carry out day to day transactions, mostly
determined by a persons income.
MT = f(Y)
2) Precautionary Demand - to meet unforeseeable expenses, determined by a
persons income.
Mp = f(Y)
3) Speculative Demand - to realize the gain of holding money vis a vis bonds
Keynes classifies the financial assets into Money (M) and Bonds (B)
MS = f (Y, i)

Combining the three motives, the liquidity preference (demand for

money) = L( Y, i)
5

Step 1: Link between money demand and

interest rates and income
The demand for money depends on real income and interest rate.
The demand for real balances (money) is defined as:

L kY hi
The parameters k and h reflect the sensitivity of the demand for real
balances to the level of Y and i

Demand for Money graphically

The demand function for real balances
implies that for a given level of
income, the quantity demanded is a
decreasing function of i
The figure illustrates the inverse
relationship between money
demand and i money demand
curve

Supply of Money graphically

The nominal quantity of money
supplied, M, is controlled by the
central bank.

Step 2: Equate the demand for money with the

Supply of Money: Deriving the LM Curve

Step 2: Equate the demand for money with the

Supply of Money: Deriving the LM Curve
For a given level of income Y1, the corresponding demand curve for real
balances is L1 shown in panel (a) with money market equilibrium at Point E1.
Point E1 is recorded in panel (b) as a point on the money market equilibrium
schedule, or the LM curve (i1, Y1) pair is a point on LM curve.
If income increases to Y2, real money balances increase and money demand
shifts to L2 with higher level of interest rate and the new equilibrium is at point
E2.
Record E2 in panel (b) as another point on the LM curve. Pair (i2, Y2) is higher
up the given LM curve

Equation for LM curve

For the money market to be in equilibrium, Ms must equal Md:

M
kY hi
P
Solving for i:
1
M
i kY

h
P

The Slope of the LM Curve

1
M
i kY

h
P

The LM curve will be steeper,

if the responsiveness of the demand for money to income(k) is higher than
the responsiveness of the demand for money to the interest rate(h).
The LM curve will be flatter, if k<h.

When will the LM be vertical?

When will the LM be horizontal?

The Position of the LM Curve

The real money supply is held constant along the LM curve a change in
the real money supply will shift the LM curve.

Equilibrium in the Goods and Money Market

The IS and LM schedules intersect
to bring about simultaneous
equilibrium in the goods and
money markets at point E,
corresponding to the pair (i0, Y0)

Since LM schedule is based on demand for money

and supply of money, monetary policy is effective.

Problem
From the following information, calculate the equilibrium values of
investment (I), net exports (NX), and money demand (md).
expenditure sector:
C = 200 + (4/5)YD
TA = (1/8)Y - 40
TR = 60
I = 300 10i
G = 70
NX = 150 - (1/5)Y

money sector:
ms = 400
md = (1/4)Y + 100 - 5i

Problem
Sp = C + I + G + NX = 200 + (4/5)[Y- (1/8)Y + 40 + 60] + 300 - 10i + 70 + 150 - (1/5)Y
= 720 + (4/5)(7/8)Y + (4/5)100 - 10i - (1/5)Y = 800 + [(7/10) (2/10)]Y 10i
= 800 + (1/2)Y - 10i
Y = Sp ==> Y = 800 + (1/2)Y - 10i ==> (1/2)Y = 800 - 10i
Y = 2(800 - 10i) ==> Y = 1,600 - 20i IS-curve

Problem
Y = 2(800 - 10i) ==> Y = 1,600 - 20i IS-curve
ms = md ==> 400 = (1/4)Y + 100 - 5i ==> (1/4)Y = 300 + 5i ==> Y = 4(300 + 5i)
==> Y = 1,200 + 20i

LM-curve

IS = LM ==> 1,600 - 20i = 1,200 + 20i ==> 40i = 400 ==>

==> I = 300 - 10*10 = 200

i = 10

NX = 150 - (1/5)1,400 = - 130

Y = 1,400

md = ms = 400