The LM schedule Money and banking

Authorizer: Dr. Abdul Qadeer khan

Outline • Money market• Equilibrium interest rate • Level of real income determination • Goal • LM schedule• Formation • Derivation of the LM schedule • Determinants of the LM schedule• Shifts in the LM schedule • Effects of Fiscal and Monetary Policy

Money market

Money market

• Is the segment of financial market in which highly liquid assets are traded e.g. (P.I.B) Pakistan investment bonds, forex exchange rate and currency exchange.

• LM deals with the money market where as IS schedule deals with goods market

• Equilibrium of the money market requires equality between the supply and the demand for money.

Ms = Md

Equilibrium interest rate &Level of real income determination

Equilibrium interest rate

• FactorsNominal supply of moneyLevel of priceOther factors that influence public demand for real

purchasing power Level of real income

• Level of real income determination:Equilibrium level of real income is determined by the level of desired expenditures in the economy

Goal

Goal• To take the locus combination of Y & r

Equilibrium real interest rate ( r ) Equilibrium level of real income( Y )

How simultaneously determined

History and information of LM schedule

LM schedule• 1937 john hicks derived the LM schedule.• It is a Set of points which represents.

“All the combination of real income and interest rate for which the market is in equilibrium”• Before it was named as LL schedule but now LM as :

holdings of money balance (liquidity) L= quantity of money balance supplied M

Formation

Formation • The model is presented as a graph of two intersecting

lines in the first quadrant.Horizontal axis represents real income or real GDP (y)Vertical axis represents the real interest rate (r) . Point of intersection is called equilibrium point MD/P = MS/P.

Take demand curve as real money demand MD/P Take supply curve as real money supply MS/P.

Formation

Interest rate

MD/P

YReal income

MS/P

re0

r

Assumption

•Take real money supply constant (Ms/p). And assume that it is fixed by the central bank.

•If not then the locus combination will not be in same position

Deriving the L-M Curve

Derivative of the LM schedule• Previous chapter that : If real money supply falls then our demand will

shift towards leftward • If real money supply increase then our demand curve will move

towards rightward.

If real money supply increase(upward) figure 4a

More elaboration ……….

Deriving the L-M Curve• If we plot the equilibrium points on a separate graph then we will get

the LM schedule as it justify the definition:

“All the combination of real income and interest rate for which the market is in equilibrium”

Deriving the L-M Curve (figure 4b)

More elaboration ……….

More elaboration ……….

Determinants of the LM schedule

Determinants of the LM schedule

The slope of the L-M curve depends on

• the interest sensitivity/ elasticity of the speculative demand for money

• the income elasticity of money demand

Shifts in the LM schedule

Properties of LM Curve• Upward sloping, Y L i* Increase/Decrease in the real money

supply shift the LM curve Rightward/Leftward.• The steepness or flatness of the LM curve describes the

elasticity or responsiveness of money demand to the nominal interest rate.

-- Steep LM curve: inelastic. -- Flat LM curve: elastic.

• An increase in moneycauses the LM curveto shift down (right)

Shifts in LM Curve due to change in Money Supply

Shifts in the LM schedule(right)

Shifts in the LM schedule(left)

Effects of Fiscal and Monetary Policy

Some important consideration • Taxes affect the IS curve, not the LM curve.• Monetary policy does not affect the IS curve, only the LM curve.• For example, an increase in the money supply shifts the LM curve

down.• Monetary contraction, refers to a decrease in the money supply

(leftward shift)• An increase in the money supply is called monetary

expansion(rightward shift)

Effects of Fiscal and Monetary Policy

Thank You