Page 159 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes

(b)
The LM-curve is a line of points showing alternative combinations of the rate of interest and the
level of income that bring about equilibrium in the money market.

Or
The LM schedule (curve) or the money market equilibrium schedule shows interest rates and
levels of income such that the demand for money is equal to its supply.

Caselet Interest Rate Too High

f the actual interest rate is higher than the equilibrium rate, for some unspecified
reason, then the opposite adjustment will occur. In this case, real money supply will
Iexceed real money demand, meaning that the amount of assets or wealth people and
businesses are holding in a liquid, spendable form is greater than the amount they would
like to hold. The behavioral response would be to convert assets from money into interest-
bearing non-money deposits. A typical transaction would be if a person deposits some of
the cash in his wallet into his savings account. This transaction would reduce money
holdings since currency in circulation is reduced, but will increase the amount of funds
available to loan out by the banks. The increase in loanable funds, in the face of constant
demand for loans, will inspire banks to lower interest rates to stimulate the demand for
loans. However, as interest rates fall, the demand for money will rise until it equalizes
again with money supply. Through this mechanism average interest rates will fall whenever
money supply exceeds money demand.

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9.3.2 Properties of LM-curve

The Slope of LM-curve: The LM-curve is positively sloped. This means that an increase in
the interest rate reduces the demand for money. To maintain the demand for money equal
to the fixed supply, the level of income has to rise. Accordingly, money market equilibrium
implies that an increase in the interest rate is accompanied by an increase in the level of
income.

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