LM curve-Money Sector Diagram

R0i (d) M

(a) A

M2 B 0 L NY

C F

(b) (c)

D G

M1

M2 = f(i) M1 = f(i) M = M 1 + M2

The LM Curve represents the equilibrium in the money sector. It is the locus of all the equilibrium pts in
the money sector. This means that all the equilibrium points in the money sector are located in it. The
LM curve indicates the Monetary Policy of the Central Bank of the country. Hence in India it represents
the Monetary Policy of the Reserve Bank of India (RBI).

Derivation of the LM Curve

The LM curve is derived from 3 important equations in the money sector. These are:
1)M2 = f(i) 2) M1 = f(i) 3) M = M1 + M2

In the first equation M2 is the speculative demand for money. It is a function of the rate of interest It is
inversely related to the rate of interest (i). So when the rate of interest rises the speculative demand for
money falls. This equation is represented by the curve AB in the top left (a) quadrant of the diagram
where interest Roi is measured on the vertical axis and M 2 is measured on the horizontal axis.

In the second equation M1 is the transaction demand for money. It is a function of the level of national
income Y. It is a positive function of the level of National Income. So when the Income rises the
transaction demand for money rises. This equation is represented by the curve FG in the lower right (c)
quadrant of the diagram above, where interest is measured on the vertical axis and M 1 is measured on
the horizontal axis.

In the third equation M is the total stock of money in the economy and it consists of M 1+M2. M1 is
marked on the vertical axis and M2 on the horizontal axis . The equation is represented by the curve CD,
where if M1 is high M2 is low and vice versa
The three curves are connected such that their axis are matched and by moving along perpendiculars
from (a) to (b) to (c) we get the coordinates in (d) where we get the curve LM.
The LM is a curve moving upward from left to right and relates rates of interest to the different levels of
national income. Thus in the money sector as the rate of interest rises the level of national income also
rises.

Significance and Shifts in the LM curve.

The LM curve indicates the Monetary Policy of the Central Bank of the country. Hence in India it
represents the Monetary Policy of the Reserve Bank of India (RBI).

Shifts in the LM curve indicate the changes in the Central Bank’s Monetary Policy. If the economy is in a
recession it will follow an expansionary Monetary Policy and increase the total stock of money in the
economy. This will cause the LM curve to shift outwards to the right. If there is inflation in the economy
the Central Bank will reduce the stock of money in the economy and follow a Tight Monetary Policy. This
will cause the LM curve to shift upwards to the left. Thus shifts in the LM curve indicate the Monetary
Policy of the Central Bank.

The Shifts can be explained by the following Diagram Fig. 2. Money Sector Equilibrium

Interest M2

M1

L2 L L1

0 National Income
In the above diagram Fig. 2 we have the rate of interest marked on the Y axis and the level of national
income on the X axis. LM is the original LM curve indicating money sector equilibrium. If the Monetary
Policy is expansionary the LM curve will move outwards to the right to L1M1 parallel to the original LM
curve. If the Monetary Policy is tightened (contractionary) the LM will move parallel to the left to L2M2.

Thus the LM curve shows how the Central Bank of any economy can reduce the impact of the business
cycles (cycles of inflation and recession) in an economy and ensure economic stability.