Meaning:
LM curve is the locus of those combinations of Y and / values for which the demand for money equals its supply.
Corresponding to IS curve in the Product Market, we derive an LM curve for the Money Market. Here, the term money market should be interpreted carefully to incorporate the creation, redemption and sale-purchase of all financial assets. In Keynesian terminology, all financial assets other than the ones included in officially defined “money proper'” are referred to as “securities”.
All “securities” are finally redeemable (and are sold and purchased in the market) in terms of officially defined money. Accordingly, equilibrium in the financial sector can be equated with equilibrium in the money market in the sense that demands for money proper is equal to its supply.
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Demand for Money:
In Keynesian model, money is demanded because it is readily ‘marketable’. Sellers of goods and services are always ready to accept it. In that sense, it is the most liquid (that is, having highest marketability) asset.
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For this reason, demand for money function is also termed ‘liquidity preference functions (L). Keynes argues that demand for money may be split up into following three parts.
Transactionary demand:
Which is meant for meeting day-to-day expenditure needs of consumers and business units (b) Precautionary demand for meeting an unexpected need for ready money and (c) Speculative demand which is meant for financing transactions in securities?
Transactionary and precautionary components of demand for money are linked to the ‘normal’ level of income and the two together happen to be only a small portion of the total demand for money.
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An overwhelmingly large proportion of demand for money is for speculative purposes which is highly responsive to changes in interest rate. This portion of demand for money is inversely related to the rate of interest.
However, once the interest rate touches it’s ‘floor level’, its demand becomes perfectly elastic and the market is ready to absorb all additions to money supply at this floor level (that is, “there is no need to lower the interest rate further). This phenomenon in termed the liquidity trap.
Graphical Illustration:
A typical liquidity preference function (that is, demand for money function), L, can also be presented graphically.
However, once the rate of interest falls to what the market believes to be the “floor level”, the demand for money become perfectly elastic with respect to interest rate, and L curve becomes parallel to X-axis. Moreover, the exact position of the negatively sloped portion of L curve would depend upon the level of income Y.
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With an increase in Y, this portion of L curve shifts upwards and to the right, but once it reaches the “floor level of interest rate”; it becomes parallel to horizontal axis and coincides with the horizontal portions of other similar L curves.
Consequently, for each level of Y, we get a separate negatively sloping portion of L curve, while their horizontal portions coincide with each other.
Supply of Money:
In Keynesian model, supply of money is regulated by the monetary authorities. In estimating the “appropriate” supply of money (Ms) needed by the economy, they take into account several factors, but totally ignore the factor of ‘rate of interest’. In other words Ms is “interest inelastic”.
Intersection of Demand and Supply Curves:
From the points of intersection of Ms Curve with successive liquidity preference curves, we can read the corresponding pairs of values of Y and /. By plotting these pairs of Y and / values we get an LM curve.
This is because when an increase in Y causes an increase in the demand for money, an increase in / reduces it, so that both Y and i have to increase (or decrease) to keep the demand for money at the same level. It should be noted that this LM curve is with reference to a given money supply. If there is an increase in Ms, we get another LM curve which is to the right side of the earlier one.
An LM curve is an iso-L curve, i.e. it represents those combinations of Y and rate of interest i which together result in that demand for money which is equal to a given money supply Ms. Therefore, a change in money supply Ms by the monetary authorities results in a new LM curve.
Intersection of IS and LM Curves:
Simultaneous Equilibrium in both Product and Money Markets is represented by the intersection of IS and LM curves.