Question

Derive the LM curve in Hick’s IS-LM M model. Start with the basic essentials of the model, and then explain the main relationship that determines the shape of LM curve. How would the monetaries draw the LM curve? How could keynes draw the LM curve? Explain the reason for different shapes.

Answer 1

Hick’s LM curve:

Money has two use, transaction demand for money and speculative demand for money. The transaction demand for money depends on income level (Y) and speculative demand for money depends on rate of interest (r). Hence, the function for demand for money is F (Y, r).

So the relation between liquidity demand for money and interest rate is given as.

Ms = Mo and Md = K (y) + l (r)

Given price level (p), as income (y) increases transaction demand for money increases. And, with increase in r, transaction demand for money decreases. Given r, as sup[ply of money increases, transaction demand for money increases. Considering supply of money is fixed, the LM curve representing money market equilibrium, is looked like:

The monetarists consider the LM curve is very inelastic and according to them it looks like: