02/05/2023 Prabha Panth 1

THE LM CURVE

Prof. Prabha Panth,Osmania University,

Hyderabad

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LM curve• Based on Keynesian theory of Liquidity

preference.• It shows equilibrium in Money Market.• Demand for money includes:

• Transaction/Precautionary demand TPr = f(Y)• Speculative demand for money Sp = f(i)

MD = L(Y, i)• With different levels of Y, there will be

different levels of D for Money.

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LM curve

• The Supply of Money is fixed by the Central Bank.

• The intersection of the DM (Liquidity preference) and SM gives the rate of interest.

• If NY increases, DM also increases, and the LP curve shifts upwards.

• This causes i to increase.

4

Derivation of LM curve

Rat

e of

in

tere

st

Rat

e of

in

tere

st

00Money NY Level

MS

MD(Y0)

i0

MD(Y1)

i1MD(Y2)

i2

i0

Y0

i1

Y1

i2

Y2

LM

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LM curve• The LM curve relates different levels of NY with

different rates of interest.• The rates of interest change, when the demand

for money changes with change in NY.• As NY increases, DM for transaction increase.• So, given SM, i has increases, with increases in

DM

• Therefore there is a positive relationship between rate of interest and levels of NY.

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Slope of LM curve

• The LM curve slopes upwards to the right.

• It shows that i increases with NY.• The slope of the LM curve depends

on:a) Elasticity of DM with respect to Y.b) Elasticity of DM with respect to i.

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Shifts in LM curve• The LM curve’s position is determined

by:a) Money supply: if money supply increases, then the LM curve will shift to the right.

b) Liquidity preference: if there is more SP demand for money, then LM curve will shift to the left.

Because level of NY does not affect LP.

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Features of LM curve1. LM curve shows the combinations of i and

level of Y, when Money Market is in equilibrium.

2. It slopes upwards to the right.3. LM curve is flatter if DM is i elastic, and

steeper when it is inelastic4. It shifts to the right when MS increases,

and to the left when MS decreases.5. It shifts to the left if there is increase in DM,

and to the right when there is decrease in DM, at given rate of interest.