Question

3. What relationship does the LM curve plot? Why does the LM curve slope upwards?

Answer 1

Answer 3

LM curve shows the relationship between interest rate and real GDP at which money market is in equilibrium.

Money market is in equilibrium when Real money demand = Real money supply

=> Md = Ms

lets take simple linear real money demand function. Md = aY - bi where a and b are constants and i = interest rate and Y = Real GDP or Real Income. As income increases you will demand more money hence as income increases money demand increases and if interest rate increases you will prefer to save and hence Money demand will increase. Hence Md = aY - bi

According to Keynes money supply is set by the government and is considered as constant.

hence at equilibrium Ms = Md = aY - bi , where Ms= Real money supply and is constant and Md = Real money demand

=> At equilibrium Ms = aY - bi. Hence In order for money market to be equilibrium If real income or GDP increases and we want Ms to be constant i = interest rate should also increase. Hence in order for money market to be in equilibrium if real Income increases then Interest rate should also increases. As LM curve shows the relationship between interest rate and real GDP at which money market is in equilibrium, implies the LM curve slope upwards