# LM curve

Money Market and the LM Curve

MACROECONOMICS

Macroeconomics

Prof.

N. Gregory MankiwRudra SensarmaKozhikode

Indian Institute of Management

www rudrasensarma info

www.rudrasensarma.info

®

PowerPoint Slides by Ron Cronovich

© 2013 Worth Publishers, all rights reserved

Learning objectives & outcomes

• Money Market & the LM Curve

– Real Money, Real Income & Interest Rate

y,

– Deriving the LM Curve

– Monetary Policy & the LM Curve

2

Financial Markets (Money Market) and the LM

Relation

R l i

The interest rate is determined by the

equality of the real supply of and demand

for money:

M = L (Y , i)

( )

P

Deriving the LM Curve

Deriving the LM Curve

The Effects of an

Increase in Income on

the Interest Rate

An increase in income

leads to an increase in

the demand for money.

Given the money supply,

this leads to an increase

in the equilibrium interest

rate.

Deriving the LM Curve

Deriving the LM Curve

Equilibrium in money market implies

that increase in income leads to

increase in the interest rate.

Plot this relationship between

interest rate and income: LM curve.

The LM curve is upward sloping.

Why the LM curve is upward sloping

Why the LM curve is upward sloping

• An increase in income raises money demand

An increase in income raises money demand.

• Since the supply of real balances is fixed, there is now excess demand in the money market at

is now excess demand in the money market at

the initial interest rate.

• Th i

The interest rate must rise to restore

i

equilibrium in the money market.

Shifts of the LM Curve

Suppose RBI causes an increase in money supply

(a) The money market

(b) The LM curve

equilibrium

i

Ms

LM

i

Ms’

LM’

i

i'

i

Md

M/P

i'

Y

Y

NOW YOU TRY

Shifting the LM

Shifting the

Shifting the LM curve

• Suppose a wave of credit card fraud causes

pp

consumers to use cash more frequently in

transactions.

• Use the money market equilibrium model to

show how these events shift the LM

show how these events shift the LM curve.

8

ANSWERS

Shifting the LM

Shifting the

Shifting the LM curve

( )

(a) Equilibrium in money

q

y

(b) Th LM curve

The

market

LM’

LM

i'

i’

Md’

i

Md

M/P

i

Y

9

Putting the IS and LM relations

together: The IS‐LM Model

•Equilibrium iin goods market

E ilib i

d

k

implies that increase in

interest rate leads to

decrease in output.

•Equilibrium in financial

(money) markets implies that

increase in output leads to

increase in interest rate.

•When IS curve intersects

LM curve, both goods and

financial (money) markets

are in equilibrium.

IS relation: Y C(Y T ) I (Y , i ) G

l i

LM relation:

M

= L (Y) , i)

YL(i

P

Fiscal Policy, Output & the Interest Rate

The Effects of an

Increase in Government

Expenditure

An increase in G

shifts th IS curve t

hift the

to

the right, and leads

to an increase in the

equilibrium level of

output and the

equilibrium interest

rate.

i

LM

i'

i

IS

IS’

IS

Y

Y’

Y

Fiscal Policy, Output & the Interest Rate

i

LM

The Effects of an

The Effects of an

Increase in Taxes

An increase in T

shifts the IS curve t

hift th

to

the left, and leads to

a decrease in the

equilibrium level of

output and the

equilibrium interest

rate.

i

i'

IS

IS’

Y’ Y

Y

Monetary Policy, Output & the

Interest Rate

The Effects of a

The Effects of a

Monetary

Expansion

Increase in M shifts

the LM curve to the

right, and leads to

higher output and a

lower interest rate.

When is monetary policy

ineffective? IS IS’

1. When investments are

driven by ‘animal

di

b ‘ i l

spirits’ i.e. they do not

respond to interest

respond to interest

rates

IS curve is vertical

IS curve is vertical

Monetary policy becomes

ineffective

Fiscal policy needed

i

LM

LM’

i

i'

Y Y’

Y...

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