The LM Curve

The quantity theory of money equation

MV = PY

where

M is the nominal money supply;

V is the velocity of money, the average rate at which money circulates through the economy to facilitate expenditure;

P is the price level;

Y is real income/expenditure.

The supply and demand for real money balances:

M/P = (M/P)_D = kY

where k = 1/V reflects how much money people want to hold for every currency unit of real income.

Demand for real money balances is an increasing function of real income and a decreasing function of the interest rate.

M/P = M(r,Y)

Given the real money supply (M/P), an increase in real income must be accompanied by an increase in the interest rate in order to keep the demand for real money balances equal to the supply. – The LM curve.