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.