Editing IS–LM model (section)

===LM (liquidity-money) curve===

[[File:Money Market diagram.svg|class=skin-invert-image|thumb|270px|The money market equilibrium diagram.]]

The LM curve shows the combinations of interest rates and levels of real income for which the money market is in equilibrium.  It shows where money demand equals money supply.  For the LM curve, the independent variable is income and the dependent variable is the interest rate.

In the money market equilibrium diagram, the liquidity preference function is the willingness to hold cash. The liquidity preference function is downward sloping (i.e. the willingness to hold cash increases as the interest rate decreases). Two basic elements determine the quantity of cash balances demanded:
# [[Transactions demand]] for money: this includes both (a) the willingness to hold cash for everyday transactions and (b) a precautionary measure (money demand in case of emergencies). Transactions demand is positively related to real GDP. As GDP is considered exogenous to the liquidity preference function, changes in GDP shift the curve. 
# [[Speculative demand]] for money: this is the willingness to hold cash instead of securities as an asset for investment purposes. Speculative demand is inversely related to the interest rate. As the interest rate rises, the [[opportunity cost]] of holding money rather than investing in securities increases. So, as interest rates rise, speculative demand for money falls.

Money supply is determined by central bank decisions and willingness of commercial banks to loan money. Money supply in effect is perfectly [[elasticity (economics)|inelastic]] with respect to nominal interest rates. Thus the money supply function is represented as a vertical line – money supply is a constant, independent of the interest rate, GDP, and other factors. Mathematically, the LM curve is defined by the equation <math>M/P=L(i,Y)</math>, where the supply of money is represented as the [[Real versus nominal value (economics)|real]] amount ''M''/''P'' (as opposed to the nominal amount ''M''), with ''P'' representing the [[price level]], and ''L'' being the real demand for money, which is some function of the interest rate and the level of real income.

An increase in GDP shifts the liquidity preference function rightward and hence increases the interest rate. Thus the LM function is positively sloped.