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3.3.2 The money market and the LM curve

Equilibrium in the money market occurs where the demand for and supply of

money are equal. The money supply is assumed to be exogenously determined

by the authorities. Within the model three main motives for holding

money are identified: the transactions, the precautionary and the speculative

motives. The demand for transactions and precautionary balances is assumed

to vary positively with income. The demand for speculative or idle balances

depends on the current level of the rate of interest relative to the normal rate

of interest. By assuming that different people have different expectations

about the future course of the rate of interest, it is possible to postulate that

the demand for speculative balances will vary inversely with the rate of

interest (see Figure 3.1). The higher the current level of the rate of interest

(relative to the level regarded as normal), the greater the number of individuals

who expect future reductions in the rate of interest (and therefore rising

bond prices) and the less speculative balances demanded, and vice versa. Of

particular importance is the theoretical possibility that, at low interest rates,

which would be expected to prevail in conditions of underemployment equilibrium,

the demand for money could become perfectly elastic with respect to

the rate of interest. This is illustrated by the horizontal section of the curve at

r* in Figure 3.1. At r* expectations converge as everyone expects that the only

future course of the rate of interest is upwards, so that the demand for money

becomes perfectly interest-elastic: the so-called ‘liquidity trap’. With regard

to the liquidity trap, it is interesting to note that Keynes put it forward only as

a theoretical possibility and even commented that he was not aware of it ever

having been operative in practice (see Keynes, 1936, p. 207). Nevertheless,

as we will discuss in section 3.4.2, it became especially important to the

analysis of underemployment equilibrium in the orthodox Keynesian model.

The LM curve traces out a locus of combinations of interest rates and income

associated with equilibrium in the money market. The LM curve derives its

name from the equilibrium condition in the money market where the demand

for money, or what Keynes called liquidity preference (L), equals the supply of

money (M). Given the assumption that the demand for money is positively/

negatively related to income/interest rate, the LM curve is upward-sloping (see

Figure 3.2). Ceteris paribus, as income rises the transactions and precautionary

demand for money increase, which, given the supply of money, necessitates a

higher rate of interest to reduce the speculative demand for money and maintain

equilibrium in the money market. The slope of the LM curve depends on

the income elasticity and the interest elasticity of the demand for money. The

LM curve will be steeper (flatter) the higher (smaller) the income elasticity and

Figure 3.1 Demand for speculative balances

Figure 3.2 The generalized IS–LM model

the smaller (greater) the interest elasticity of the demand for money. For example,

ceteris paribus, the more the demand for money increases following a

given increase in income, the larger will be the rise in the rate of interest

required to maintain equilibrium in the money market, generating a steeper LM

curve. In the limiting cases of (i) the so-called ‘classical range’ (where the

demand for money is perfectly interest-inelastic) and (ii) the liquidity trap

(where the demand for money is perfectly elastic with respect to the rate of

interest) the LM curve will be vertical and horizontal respectively.

Finally, it is important to remember that the LM curve is drawn for a given

money supply, price level and expectations, so that expansionary monetary

policy (that is, an increase in the supply of money) shifts the LM curve

downwards to the right, and vice versa. Following an increase in the money

supply, and a given income elasticity of the demand for money, any given

level of income must be associated with a lower interest rate to maintain

equilibrium in the money market. The extent to which the LM curve shifts

depends on the interest elasticity of the demand for money. A given increase

in the supply of money will cause a small/large shift in the LM curve where

the demand for money is relatively interest-elastic/inelastic as equilibrium in

the money market will be restored by a small/large fall in the interest rate.

Readers should verify this for themselves.