The ISLM Model 591 CHAPTER 22 Ms Interest Rate, i Interest Rate, i i3 i2 i1 M d(Y3) M d(Y2) M d(Y1) M/P i3 Excess Supply of Money A i2 i1 Y1 Quantity of Real Money Balances, M/P (a) Market for money FIGURE 22-8 LM Curve Excess B Demand for Money Y2 Y3 Aggregate Output Y (b) LM curve Deriving the LM Curve Panel (a) shows the equilibrium levels of the interest rate in the market for money that arise when aggregate output is at Y1, Y2, and Y3 Panel (b) plots the three levels of the equilibrium interest rate i1, i2, and i3 corresponding to these three levels of output; the line that connects these points is the LM curve When aggregate output is Y1, the money demand curve is M d (Y1) It slopes downward because a lower interest rate means that the opportunity cost of holding money is lower, so the quantity of money demanded is higher Equilibrium in the market for money occurs at point 1, at which the interest rate is i1 When aggregate output is at the higher level Y2, the money demand curve shifts rightward to M d (Y2) because the higher level of output means that at any given interest rate, the quantity of money demanded is higher Equilibrium in the market for money now occurs at point 2, at which the interest rate is at the higher level of i2 Similarly, a still higher level of aggregate output, Y3, results in an even higher level of the equilibrium interest rate, i3 Panel (b) plots the equilibrium interest rates that correspond to the different output levels, with points 1, 2, and corresponding to the equilibrium points 1, 2, and in panel (a) The line connecting these points is the LM curve, which shows the combinations of interest rates and output for which the market for money is in equilibrium The positive slope arises because higher output raises the demand for money and thus raises the equilibrium interest rate WHAT THE LM CURVE TELLS US The LM curve traces out the points that satisfy the equilibrium condition that the quantity of money demanded equals the quantity of money supplied For each given level of aggregate output, the LM curve tells us what the interest rate must be for there to be equilibrium in the market for money As aggregate output rises, the demand for money increases and the interest rate rises, so that money demanded equals money supplied and the market for money is in equilibrium Just as the economy tends to move toward the equilibrium points represented by the IS curve, it also moves toward the equilibrium points on the LM curve If the economy is located in the area to the left of the LM curve, there is an excess supply of money At point A, for example, the interest rate is i3 and aggregate output is Y1 The interest rate is above the equilibrium level, and people are holding more money than they want to To eliminate their excess money balances, they