The LM Curve Money and Money Demand Varies as Total Income

The LM Curve:

If the money stock is stable, then the truth that demand for money depends on real GDP Y means that the equilibrium nominal interest rate varies whenever real GDP Y varies. At every possible level of total income Y, there is a dissimilar curve showing money demand as a function of the nominal interest rate as. With a fixed money supply every of these money demand curves produces a different equilibrium nominal interest rate. If real GDP Y rises as well as the money supply Ms doesn’t, the nominal interest rate must increase too if the money market is to remain in equilibrium. With higher incomes households as well as businesses want to hold more money. However if the money supply doesn’t increase then in aggregate their money holdings cannot grow. Something should curb their demand for liquid cash holdings and so keep money demand equal to money supply, and that incredible is a higher nominal interest rate, a higher chance cost of holding money.

Money Demand Varies as Total Income Y Varies:

1465_money demand and total income.jpg

Legend: The elevated the level of total income, the elevated is the quantity of money demanded for any given interest rate and (for a fixed money stock) the higher will be the equilibrium interest rate.

If we draw another figure with the nominal interest rate i=r+π on the vertical axis and the level of total income Y on the horizontal axis. For every possible value of Y on the x-axis plot the point whose y-axis value is the equilibrium nominal interest rate as shown in figure. The consequence is the LM curve the economy’s current level of the real money stock Ms/P. The LM curve grade upward: at a higher level of real GDP Y, the equilibrium small interest rate is higher.

From Money Demand to the LM Curve:

1141_money demand to lm curve.jpg

Legend: The LM Curve on the right notifies us what the nominal interest rate will be for each value of national income Y.

The equation for the LM curve is merely the money demand function rewritten with the real GDP by itself on the left-hand side:

1457_lm curve and gdp.jpg

This equation notifies us that monetary policy changes that increase the nominal money supply shift the LM curve to the right: the similar equilibrium nominal interest rate i corresponds to a higher level of real GDP Y.  Financial policy changes that decrease the nominal money supply shift the LM curve in and to the left. Likewise a decline in the price level boosts the real money supply (M/P) and shifts the LM curve out to the right. A increase in the price level decreases the real money supply (M/P) and shifts the LM curve in to the left.

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