LM curve

Topics: Economics, Money, Money supply Pages: 9 (747 words) Published: November 6, 2013
10
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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