Why lm curve is positively sloped

At higher real income levels the demand for real money balances is greater. Thus, reduction of the real rate of interest is necessary to reduce the quantity of real balances demanded for asset purposes so as to bring about equality between supply and demand in the market.

The liquidity trap segment of the liquidity preference curve demand for real money balances curve also shows up in the LM curve. If in fact there is a minimum expected level of real interest rates where the asset demand for real money balances is perfectly elastic with respect to the market real rate of interest, the LM curve also would be perfectly elastic in this region. For example, in Figure The same quantity of real balances demanded at the real income level of Y 2 and the real interest rate of r 1 would have been demanded at lower levels of real income.

The slope of the LM curve depends upon the income elasticity and the interest elasticity of the demand for money. Income-elasticity measures the responsiveness of the demand for money to changes in income while interest elasticity measures the responsiveness of the demand for money to changes in the rate of interest. The larger the income-elasticity, and the lower the interest-elasticity of the demand for money, the steeper the LM curve will be.

In case the demand for money is relatively insensitive to the interest rate, the LM curve is nearly vertical. If the demand for money is very sensitive to the interest rate, then the LM curve is close to horizontal.

In that case, a small change in the interest rate is accompanied by a large change in the level of income to maintain money-market equilibrium. We know that the real money supply is held constant along the LM curve. It follows that the position of the curve depends upon the amount of real money supply available in the market. A change in the real money supply will shift the LM curve. Let us consider the effect of an increase in real money supply as a result of which the money supply schedule shifts to the right.

At the given level of income and hence with the given demand for real money balances, there is now an excess supply of money. To restore money market equilibrium at the initial level of income, the interest rate has to decline which means a downward shift of the LM curve.

Another way of adjustment in the money market is to change the level of income. In this case of the increase in money supply, the excess supply of money can be absorbed by increased demand for real balances arising out of the increased level of income induced by the fall in interest rate. When the level of income increases as a result of the fall in the rate of interest, the LM curve is shifted to the right. We can thus conclude that an increase in the supply of real money balances MIP leads to the rightward shift of the LM curve.

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These cookies ensure basic functionalities and security features of the website, anonymously. The cookie is used to store the user consent for the cookies in the category "Analytics". The equilibrium in the money market is shown in Figure When the money supply is chosen by the monetary authority, the interest rate is the price that brings the market into equilibrium. Sometimes, in some countries, central banks target the money supply.

Alternatively, central banks may choose to target the interest rate. This was the case we considered in Chapter 10 "Understanding the Fed". Figure To trace out the LM curve, we look at what happens to the interest rate when the level of output in the economy changes and the supply of money is held fixed.

At the higher level of income, money demand is shifted to the right; the interest rate increases to ensure that money demand equals money supply. At each point along the LM curve, money supply equals money demand. We have not yet been specific about whether we are talking about nominal interest rates or real interest rates.

In fact, it is the nominal interest rate that represents the opportunity cost of holding money. When we draw the LM curve, however, we put the real interest rate on the axis, as shown in Figure The simplest way to think about this is to suppose that we are considering an economy where the inflation rate is zero.

In this case, by the Fisher equation, the nominal and real interest rates are the same. In a more complete analysis, we can incorporate inflation by noting that changes in the inflation rate will shift the LM curve.

Changes in the money supply also shift the LM curve. It incorporates both the dependence of spending on the real interest rate and the fact that, in the short run, real GDP equals spending. The IS curve is shown in Figure The IS curve is downward sloping: as the real interest rate increases, the level of spending decreases.

The dependence of spending on real interest rates comes partly from investment. As the real interest rate increases, spending by firms on new capital and spending by households on new housing decreases. Consumption also depends on the real interest rate: spending by households on durable goods decreases as the real interest rate increases.

The connection between spending and real GDP comes from the aggregate expenditure model. Given a particular level of the interest rate, the aggregate expenditure model determines the level of real GDP.

Now suppose the interest rate increases. This reduces those components of spending that depend on the interest rate. In the aggregate expenditure framework, this is a reduction in autonomous spending. The equilibrium level of output decreases. Combining the discussion of the LM and the IS curves will generate equilibrium levels of interest rates and output. Note that both relationships are combinations of interest rates and output.

Solving these two equations jointly determines the equilibrium. This is shown graphically in Figure This just combines the LM curve from Figure Comparative statics results for this model illustrate how changes in exogenous factors influence the equilibrium levels of interest rates and output. For this model, there are two key exogenous factors: the level of autonomous spending excluding any spending affected by interest rates and the real money supply.

We can study how changes in these factors influence the equilibrium levels of output and interest rates both graphically and algebraically. Variations in the level of autonomous spending will lead to a shift in the IS curve, as shown in Figure If autonomous spending increases, then the IS curve shifts out. The output level of the economy will increase. Interest rates rise as we move along the LM curve, ensuring money market equilibrium. One source of variations in autonomous spending is fiscal policy.

Autonomous spending includes government spending G. Thus an increase in G leads to an increase in output and interest rates as shown in Figure Variations in the real money supply shift the LM curve, as shown in Figure If the money supply decreases, then the LM curve shifts in. This leads to a higher real interest rate and lower output as the LM curve shifts along the fixed IS curve.

We can represent the LM and IS curves algebraically. For simplicity, suppose that the inflation rate is zero, so the real interest rate is the opportunity cost of holding money.

Assume that real money demand takes a particular form:. In this equation, L 0 , L 1 , and L 2 are all positive constants.