Equation nos. 2 shows positive relation between ‗Y‘ and ‗L‘ and
inverse relation between
‗i‘ and ‗L‘. Equation nos. 1 can be restated
as
____________ (3)
Equation nos. 3 shows equilibrium rate of interest.
The LM schedule shows all combination of interest rate and
the level of income such that the money market is in equilibrium.
This is derived in the following diagram
Interest Rate
LM
E
0
i
i
L
Real Money Balance
(B)
(A)
Income / Output
0
E
E
E
i
i
2
2
2
1
1
1
2
1
L (Y )
(Y )
2
1
M
P
Y
Y
1
2
FIGURE 8.4: DERIVATION OF THE LM CURVE
The LM curve in Panel ‗B‘
of the diagram represents
combinations
of interest rate and income,
which keep the money
market in equilibrium.
In Panel ‗A‘
of the diagram,
demand and supply of money
ar
e shown. The supply curve is vertical because both ‗M‘ and ‗P‘
are assumed to be constant.
The demand curve or ‗L‘ curve shift to the right along with an
increase in level of income. At Y
1
level
of income,
the demand
curve ‗L‘ intersects
the supply curve at point E
1
and hence the
equilibrium interest is i
1
.
M
hi
kY
P
1
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