Deriving the Liquidity Preference-Money Supply (LM) Curve

income (Y)

money supply

slope

This Demonstration illustrates how the liquidity preference–money supply (or LM) curve is formed; the curve shows equilibrium points in the money market. In the money market, money supply is a fixed amount determined by the central bank, whereas money demand is a downward-sloping function

r

(interest rate) as a function of

Y

(income) and

M

(quantity of money). Money demand reflects people's demand for liquidity; at a higher rate of interest, which makes bonds more valuable, people choose to hold bonds instead of liquidity and vice versa for lower rates of interest. The intersection point between money supply and money demand, which corresponds to a certain interest rate and level of income, can be plotted as a point on the LM curve, which is the interest rate as a function of income. As income rises and the money demand curve shifts up, the successive equilibrium points in the money market are plotted along the LM curve.