Money Market

and
The LM Curve
BY:-
MANIK MITTAL
LM Curve
• LM Curve shows combinations of interest rates and levels of output s.t. money demand equals
money supply

• It is derived in 2 steps
i. Explain, why money demand depends on interest rates and income
ii. Equate money demand with money supply and find the combinations of income and interest rates
that keep the money market in equilibrium.
Money Market
• Money Market is where the demand and supply of money is being generated
• Demand for money is demand for real money balances
• Demand for money depends on the level of real income and the interest rate
i. Individuals hold money to pay for their purchases which depends on income
ii. Depends on cost of holding money

• Individuals can economize on their holdings of cash by making transfers from money to bonds
• The demand for real balances, which we denote as L , is expressed as-
L = kY- hi (k , h >0)
Graphical Representation
• L = kY- hi (k , h >0)

• Parameters k and h reflect the sensitivity of

the demand for real balances to the level of
income and the interest rate

• Implies that for a given level of income,

quantity demanded is decreasing function of
rate of interest
Money Market Equilibrium
• To study equilibrium, we have to see how supply of money is determined
• Nominal quantity of money, M, is determined by Central bank
• At constant price level (P), real money supply becomes M/P
• LM curve can be obtained by combining the demand curve for real balances and the fixed supply of real
balances
• For the money market to be in equilibrium, demand has to equal supply
M/P=kY-hi
or
i=1/h(kY-(M/P))
LM Curve (Graphical
Representation)

• Shows combinations of i and • We record E2 as point of equilibrium

income levels and similar way record points for all
• E1 and E2 are the equilibrium income levels
• This gives us LM Schedule
points
• Slope depends on k and h