LM curve

LM Curve

Objective:
(a) The meaning of the LM curve and how it is derived;
(b) What determines the slope of the LM curve; and
(c) What determines the position of the LM curve.

The LM curve shows the combinations of interest rate and income that brings about equilibrium in the money market. Equilibrium in the money market occurs when the demand for real money balance equals the supply of real money balance.

Recall that there are three motives for holding money – the transaction demand for money, the precautionary demand for money and the speculative demand for money. While the first two
motives for holding money are positively related to income, the speculative demand for money is inversely related to interest rate. The demand for real money balance is therefore a function of:

Md/P = L (r, Y)