Scribd
Upload
122 views11 pages

Financial Markets and The LM Curve Relation

The document discusses the LM curve, which shows combinations of national income and equilibrium interest rates consistent with money supply and demand being equal. The LM curve is upward sloping, as an increase in income at a given interest rate leads to higher money demand and equilibrium interest rate. Disequilibrium points on the LM curve occur when money supply does not equal demand, causing interest rates to rise or fall. An increase in money supply shifts the LM curve downward, while a decrease shifts it upward.

Uploaded by

Zara Sikander
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
122 views11 pages

Financial Markets and The LM Curve Relation

The document discusses the LM curve, which shows combinations of national income and equilibrium interest rates consistent with money supply and demand being equal. The LM curve is upward sloping, as an increase in income at a given interest rate leads to higher money demand and equilibrium interest rate. Disequilibrium points on the LM curve occur when money supply does not equal demand, causing interest rates to rise or fall. An increase in money supply shifts the LM curve downward, while a decrease shifts it upward.

Uploaded by

Zara Sikander
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

THE LM CURVE

The LM (Liquidity Preference = Money Demand) curve shows combinations of National Income and corresponding values of equilibrium Interest rates.

This is consistent with the equality of Money Supply and Money Demand at a given price level.
Essentially it is the money market equilibrium curve. The LM relation: In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i:

M YL(i ) P

DERIVING THE LM CURVE

An increase in income leads, at a given interest rate, to an increase in the demand for money due to higher transactions demand. Given the money supply, this leads to an increase in the equilibrium interest rate.

DERIVING THE LM CURVE

Equilibrium in financial markets implies that an increase in income leads to an increase in the interest rate. The LM curve thus plots the equilibrium interest rate associated with each possible Y. The LM curve is upwardsloping.

POINTS OF DISEQUILIBRIUM ON LM
The point B on LM curve shows points (Y, i). This point implies disequilibrium as MS>MD i.e. Excess Supply of Money. People now tend to buy bonds and the Demand for bonds goes up. This results in bond prices rising and consequently, lowering of interest rates. This in turn causes Investment to rise, shifting AE and AD outward or upward.

POINTS OF DISEQUILIBRIUM ON LM
The point C on LM curve shows points (Y, i). This point implies disequilibrium as MD>MS i.e. Excess Demand of Money.

People now tend to sell bonds in order to replenish cash and the Supply of bonds goes up.
This results in bond prices lowering and consequently, interest rates tend to rise. This in turn causes Investment to lower, shifting AE and AD inward or downward.

If , , , , ,

An increase in money leads the LM curve to shift down. An increase in the Money Supply may be due to the following reasons:

SHIFTS OF THE LM CURVE

The CB adopts Expansionary Monetary Policy, prints more money thus increasing Nominal Money Supply. For constant price level, Real Money Supply goes up. Price level goes down, increasing Real Money Supply

An decrease in money leads the LM curve to shift up. An decrease in the Money Supply may be due to the following reasons:

SHIFTS OF THE LM CURVE

The CB adopts Contractionary Monetary Policy, prints lesser money thus decreasing Nominal Money Supply. For constant price level, Real Money Supply goes down. Price level goes up, decreasing Real Money Supply.

You might also like