As a member, you'll also get unlimited access to over 75,000 lessons in math, English, science, history, and more. Plus, get practice tests, quizzes, and personalized coaching to help you succeed.
Try it risk-freeAlready registered? Log in here for access
Martin has 16 years experience in Human Resources Information Systems and has a PhD in Information Technology Management. He is an adjunct professor of computer science and computer programming.
In macroeconomics terms, LM refers to the liquidity of money. As interest rates increase, the demand for money decreases. LM is really part of a larger model, the IS-LM model, where IS-LM stands for Investment Saving - Liquidity Preference Money Supply. These large words are basically just used to model money and income in an economy.
The models are used to define points of equilibrium, or balance; in other words, intersecting values where the demanded money equals the amount available to invest. While the formulas are a little more complex, it boils down to the basic economic analysis of supply versus demand.
The LM equation calculates the demand for money, and the equation is represented here:
L = k * Y - h * I
When we talk about real money, we aren't comparing real cash to Monopoly money. Instead, real money is adjusted for inflation. This tells us the true purchasing ability of money, or in essence, what your money can get you. The demand for money also depends on income. The more you make, the more you spend, or save in offshore accounts. It also depends on the interest rate, since people also leverage their money through investing.
We're subtracting the interest rate. As interest rates rise, people tend to invest their money.
The variables k (income sensitivity) and h (interest sensitivity) are modifiers that are added to income and the interest rates and will have value greater than zero. When talking about sensitivity in this case, we're talking about the likelihood of change.
Before we can map out the full LM curve, let's take a look at the demand for money, the L in the equation, in graph form. The LM equation can be used to create a straight line, much as the standard math formula (y = mx + b).
We'll put the interest rate on the y-axis, since this is the independent variable; we'll put L on the x-axis, since this is the demand for money. When interest rates go down, so does the demand for money. Again, we're talking about real money, not Monopoly money or pre-inflation dollars.
This graph is showing two sample calculations for L as plotted on the demand for money graph.
 |
As national income increases, the demand curve shifts upward and outward, toward L on the graph. The size of the shift depends on the increase in income and the income sensitivity of the demand for money.
When the interest sensitivity for real money goes up, the slope of the demand curve is less steep. A small decrease in interest rates causes a larger increase in the demand for money.
There's one more thing to evaluate before we get to the full LM, and that is the money supply. In our example, we'll keep it simple and keep the money supply at a fixed rate. This means that it'll show up on the graph as a vertical line. In the following graphic, we've placed the money supply line on top of the demand for money graph:
 |
Note the two circles and intersection points at interest points one and two. This indicates an equilibrium (remember, that means balanced) between demand and money supply at those points of interest.
Now that we have the building blocks set, let's look at the LM curve.
On the left of our graph, we show the demand for money graph. We've now added a graph to show the demand for money against Y1 and Y2 income values. The dashed line crosses the money supply, and hits the first equilibrium interest rate at i1.
 |
When the real interest rate goes up, real income goes up. In our graph above, we're showing two points where the money market is in equilibrium.
The LM line shifts to the right if any of the following conditions are met:
The LM curve is a graphical representation of the equilibrium in the money market. L denotes liquidity and M equals money. Equilibrium is really just a fancy term for 'balance.' Demand for money is defined by the equation L = kY - hi, where L is the demand for inflation-adjusted money; k is income sensitivity of demand; Y is income; h is interest sensitivity of demand; and i is the interest rate. These factors affect the slope of the LM curve. For example, an increase in interest rates reduces the amount of money demanded, and an increase in income drives it up to the right.
To unlock this lesson you must be a Study.com Member.
Create your account
Already a member? Log In
BackAlready registered? Log in here for access
Did you know… We have over 200 college courses that prepare you to earn credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the first two years of college and save thousands off your degree. Anyone can earn credit-by-exam regardless of age or education level.
To learn more, visit our Earning Credit Page
Not sure what college you want to attend yet? Study.com has thousands of articles about every imaginable degree, area of study and career path that can help you find the school that's right for you.
Back To Course
Introduction to Business: Homework Help Resource25 chapters | 508 lessons | 1 flashcard set
{{courseNav.course.topics.length}} chapters | {{courseNav.course.mDynamicIntFields.lessonCount}} lessons | {{course.flashcardSetCount}} flashcard set{{course.flashcardSetCoun > 1 ? 's' : ''}}
Next Lesson
| 30 day money back guarantee | |||
|
Starting Original Price |
/yr | /mo | |
| Just Just | /day | ||
| Discount For months |
- % - | / | |
|
Price after trial Starting Price starting today |
/ | ||
| Just Just | /day | ||
| Save % off monthly plan | /mo | ||
| Just | /mo | ||
| Price | /yr | ||
Your Cart is Empty. Please Choose a Product.
Study.com video lessons have helped over 30 million students.
"I learned more in 10 minutes than 1 month of chemistry classes"
- Ashlee P.
"I aced the CLEP exam and earned 3 college credits!"
- Clair S.
Over 65 million users have prepared for {{displayNameByProductKey[registrationData.product || cocoon]}} and other exams on Study.com
"The videos have changed the way I teach! The videos on Study.com accomplish in 5 minutes what would take me an entire class."
- Chris F.
Over 65 million users have prepared for {{displayNameByProductKey[registrationData.product || cocoon]}} and other exams on Study.com
Over 65 million users have prepared for {{displayNameByProductKey[registrationData.product || cocoon]}} and other exams on Study.com
