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Lesson 3: IS-LM

# LM part of the IS-LM model

How the theory of liquidity preference drives demand for money and the LM (liquidity preference-money supply) curve. Created by Sal Khan.

## Want to join the conversation?

• @ So, if r is the price of money, and Y is it's quantity,
Is the IS the demand curve for money, and the LM the supply curve?
• `LM` represents the price (in interest rate) that entrepreneurs are willing to pay in order to acquire capital to invest in a project. As the economy improves, there is more of a reason to engage in new entrepreneurial activities, so ceteris paribus they would be willing to pay more then. So a higher GDP drives up demand for investment capital on the `LM` curve.

`IS` represents the price (in interest rate) that investors are willing to accept in order to lend capital to invest in a project. As the economy improves, more short-term basic needs are met and so there is more of a reason to save, so ceteris paribus the savers have more money to lend, so they would be willing to accept less in interest in order to invest. So a higher GDP drives up demand for borrowers of capital on the `IS` curve. And, as every saver scrambles to find borrowers, they bid down the interest rate.

If these graphs are confusing, keep in mind they are just silly little ways to help you think about big problems. The important thing is the logic, not the graph.
• Does demand of money indicate the amount of money that people want to hold in cash rather than investing in bonds ?
• When preference for liquidity goes up, this means that demand to hold liquid assets increases. This causes a upwards shift of the demand curve, L(r,y). Resulting a leftward shift of the LM curve along the IS curve.

Why and upwards shift of the demand curve?
With the increase in demand for liquid assets, there is insufficient supply of money to go around, more borrowers than lenders, banks thus increase their deposit rates (cost of holding money) to encourage deposits, in turn reducing demand of liquid assets. This brings the point back to equilibrium where money supply equals demand for liquid assets.
• There is a series of questions I'd love to ask you about the Liquidity preference/Money supply model:
1) What precisely does the LM model describe ? Consumers' willingness to hold their money rather than sell money out (Liquidity Preference) or the government's monetary policy (Money Supply) ?
2) When there is a lot of economic activity going on in the market, at you say the demand for money is high, thus people request a higher price to sell their "liquid" or pay more to get access to money, resulting in a high Price of Money - Interest Rate. Can you explain this part to me a bit more carefully and specifically ?
3) According to a new equilibrium point - Lower Intererst Rate, Higher Aggregate Output - is it why some countries, such as Zimbabwe, went crazy about excessive money printing ?
• What is a liquidity trap and investment trap?
(1 vote)
• A liquidity trap is a situation, described in Keynesian economics, in which injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Common characteristics of a liquidity trap are interest rates that are close to zero and fluctuations in the money supply that fail to translate into fluctuations in price levels.[1]
• why is it that the price of currency= real interest rates?
• What happens if the preference for liquidity goes up? does the LM curve shift to the right or left? Normally a shift up would lead to a rightward shift however this makes the interest rate go down
• I guess the LM curve will NOT shift but their will be a movement along the LM curve , which will go UP thus increasing the Interest rate.
(1 vote)
• Is the IS-LM model the same as the IS-TR model ?
(1 vote)
• The IS-TR differs a bit from the IS-LM model. It is based on the Taylor Rule which is defined to target inflation instead of money supply. It all comes down to the central bankers' preferences and monetary policy. 20-30 years ago,the Central Bank used to track the markets demand for money and adjust the money supply. Nowadays most Central Banks target a stable inflation rate by adjusting the prime rate.
• Why this doesn't make sense to me:
Higher interest rates -> saving goes up -> more money to be lent out -> lower interest rates (aka the price of money for lending goes down) -> investment goes up (more people are lending again).
It doesn't seem like the higher interest rates are set to be.
(1 vote)
• More money is only lent out at the higher interest rates. If the rates go back down, the amount of money available to lend will decline. Interest is the cost of investing.