Money Market

Equilibrium: Derivation
of LM Curve
 Money Market Equilibrium: Derivation of LM Curve
The LM curve can be derived from the Keynesian theory from its analysis of money market
equilibrium. According to Keynes, demand for money to hold depends upon transactions
motive and speculative motive. It is the money held for transactions motive which is a function of
income. The greater the level of income, the greater the amount of money held for transactions
motive and therefore higher the level of money demand curve.
The demand for money depends on the level of income because they have to finance their
expenditure, that is, their transactions of buying goods and services. The demand for money also
depends on the rate of interest which is the cost of holding money. This is because by holding
money rather than lending it and buying other financial assets, one has to forgo interest.
Thus demand for money (Md) can be expressed as:
Md = L(Y, r)
Where Md stands for demand for money, Y for real income and r for rate of interest. Thus, we can
draw a family of money demand curves at various levels of income. Now, the intersection of these
various money demand curves corresponding to different income levels with the supply curve
of money fixed by the monetary authority would gives us the LM curve.
The LM curve relates the level of income with the rate of interest which is determined by
money-market equilibrium corresponding to different levels of demand for money. The LM
curve tells what the various rates of interest will be (given the quantity of money and the family of
demand curves for money) at different levels of income.
But the money demand curve or what Keynes
calls the liquidity preference curve alone rises. In
Fig. 20.2 (b) we measure income on the X-axis
and plot the income level corresponding to the
various interest rates determined at those income
levels through money market equilibrium by the
equality of demand for and the supply of money
in Fig. 20.2 (a).

It will be noticed from Fig. 20.2 (b) that the LM

The main objective of the monetary policy is to achieve economic growth, maximize employment,
maintain price stability, and attain balance of payment equilibrium. The monetary policy can be
maintained by changing the rates of interests, such as Cash Reserve Ratio (CRR) and bank rate.

In monetized economy, the monetary policy covers all economic activities. Moreover, in this type of
economy, money serves as the medium of exchange for all economic transactions.
 Open Market Operations

Open Market Operations (OMO) of a government involve the sales and purchase of
government securities and treasury bills by the central bank. If the central bank wants to
increase the supply of money with the public, it purchases government securities and
treasury bills. On the other hand, if the central bank wants to decrease the supply of money, it
sells the government securities and treasury bills. OMO is the most important and frequently
adopted measure of the monetary policy.
These operations are performed by the central bank with the help of commercial banks. The central
bank is not involved in the direct dealing with the public. Government securities are purchased by
commercial banks, financial institutions, large businesses, and individuals having high income. All
these customers of government bonds have their accounts in commercial banks.
When the customers purchase these bonds, the money is transferred from their bank
accounts to the central bank account.
For example, to reduce the chances of inflation, the central bank decrease the supply of money in
the market. In such a case, commercial banks sell government securities in the market. This
operation can be made easier when the commercial banks are under the direct control of
government.

However, in case the central bank wants to increase the supply of money in economy, it purchases
government securities from commercial banks and other purchasers of government securities. In
such a case, money moves from the central bank account to individuals’ accounts.

This leads to an increase in deposits and reserves of commercial banks. Consequently, the credit
creation capacity of commercial banks increases, which raises the flow of credit to the public.
 Bank Rate Policy:

Bank rate refers to the rate at which the central bank further discounts the bills of exchange
presented by commercial bank. (A bill of exchange is a written order used primarily in international
trade that binds one party to pay a fixed sum of money to another party on demand or at a
predetermined date.)

The central bank can rediscount the approved bills and bills of exchange only. If commercial banks
are not left with adequate cash reserves, they are required to consult the central bank for
rediscounting their bills of exchange. In this way, commercial banks borrow from the central
bank. The central bank rediscounts the bills of exchange of commercial banks as it is one of the
functions of the central bank.

For the rediscounting of bills of exchange, the central bank charges a particular amount from
commercial banks that is termed as bank rate. It is also referred as discount rate. For all other
practical purposes, bank rate is defined as the rate at which the central bank provides credit
to the commercial banks.
The central bank changes the bank rate depending on its purpose of increasing or decreasing the
flow of money banks. In case, the central bank wants to increase the credit creation capability
of commercial banks, then it decreases the bank rate and vice-versa. This is termed as the
bank rate policy or discount rate policy.

Let us understand how the bank rate comes into operation. In case, the discount rate of central
bank increases then the commercial banks also increases their discount rate and vice-versa. The
discount rate of central bank is usually kept 1% more than the discount rate of commercial banks.

The discount rate affects the flow of money in an economy. For example, in case, the central bank
needs to reduce the flow of money in banks, then it increases the discount rate. Increase in the
discount rate affects the flow of money in many ways.
Firstly, an increase in discount rate results in the decrease of net worth of government securities on
the basis of which commercial banks get loans and credit from the central bank. This further leads
to reduction in the money borrowing capability of commercial banks from the central bank.

Consequently, the reserves of commercial banks also reduce; therefore, the flow of money
decreases in the economy. Secondly, when the discount rate of the central bank increases, then the
discount rate bank also increases. This leads to an increase in the cost incurred on credit, which, in
turn, demotivates business to get their exchange discounted.

The increase in the discount rate results in the increase of rate of interest and affects the demand of
money adversely. This policy is termed as the dear money policy. In case of cheap money
policy, the process of dear money policy is reversed. Thirdly, the rate of lending by bankers gets
drastically affected by the credit rate.

An increase in the discount rate increases the credit rate. In such a case, businesses prefer to
deposit money in banks instead of borrowing money. This lead to an increase in the bank’s savings
in terms of credit. This effect is termed as deposit mobilization effect.
Cash Reserve Ratio:

CRR refers to the percentage of credit that needs to be maintained by commercial banks in
the form of cash reserve with the central bank. The main aim of CRR is to avoid any kind of
shortage of money in meeting the demand of money of depositors.

CRR is usually determined by the previous experience of banks related to the extent of cash
demanded by depositors. Commercial banks always retain their reserves beneath the safe limits.
This is because of the reason that cash reserves are non-interest bearing in nature.

This situation may result in financial crunch in banking sector. Therefore, CRR has been made
obligatory by the central bank for commercial banks. In addition, it has become an important
measure for the central bank to control the supply of money. CRR IS also termed as Statutory
Reserve Ratio (SRR).
The central bank possesses the power of changing the rate of CRR depending on economic
situations. When there is a need of contractionary monetary policy in the economy, CRR is
increased by the central bank. In this case, commercial banks need to reserve a-large amount of
their total deposits with the central bank.

As a result, the credit creation capability of commercial banks reduces, which further decreases
money supply in the market. On the other hand, in case there is a requirement of increasing supply
of money in the economy, the rate of CRR is decreased by the central bank. In such a case, the
credit creation capability of commercial banks increases.

Consequently, there would be increase in money supply. The effect of changes in CRR on money
supply can be understood with the help of an example. Suppose commercial bank A has total money
deposits of Rs. 200 million with 20% of CRR.
This implies that the bank can provide loans on the remaining amount, which is Rs. 160 million. On
the other hand if the rate of CRR increases to 25%, then the bank would be able to provide loans
on the amount Rs. 150 million.

CRR is the most effective tool then the other tools of quantitative measures of monetary policy. It is
the most popular instrument in developed countries where banking system is highly developed and
had a greater stake in the capital market. However, CRR is restricted by its dependency on the
bank credit system in the credit market.
An increase in money supply with open market
operation or reduction of bank rate shifts the LM
curve to the right and reduces the rate of interest.
This raises investment in the commodity market.
Income consequently rises. In figure 1 LM line shift to
L’M’. Consequently rate of interest reduced to r1 and
national income increased from Y0 to Y1.
Similarly by open market operation or
enhancement of bank rate reduce supply of
money, for instance, raises the rate of in­terest by
shifting the LM curve. in­vestment falls and so
income. In figure 1 LM line shift to L”M”.
Consequently rate of interest increased to r2 and
national income abated from Y0 to Y2.
Dear students that’s all for today.
If there are any questions or
queries regarding this topic
please feel free to ask me. In our
next class we will study another
new topic. Take care, good bye!!