Derivation of LM Function, Macroeconomics Video Lecture | Macro Economics - B Com

The LM function in macroeconomics represents the equilibrium condition in the money market. It shows the relationship between the interest rate and the level of income or output in an economy. The LM function is derived from the money market equilibrium equation, which states that the demand for real money balances (Md) is equal to the supply of real money balances (Ms). By rearranging this equation, we can express the LM function as: LM = L(Y, i), where Y represents the level of income or output, and i represents the interest rate.

The LM function is derived by equating the demand for real money balances (Md) to the supply of real money balances (Ms) in the money market equilibrium. The demand for real money balances depends positively on the level of income or output (Y) and negatively on the interest rate (i). On the other hand, the supply of real money balances is determined by factors such as the money supply and the price level. By equating the demand and supply of real money balances, we can derive the LM function, which shows the relationship between the interest rate and the level of income or output.

In macroeconomic analysis, the LM function represents the equilibrium condition in the money market. It shows the combinations of interest rates and income or output levels that result in the equality of money demand and money supply. The LM function helps to determine the equilibrium interest rate and level of income or output in an economy. It is an essential component of the IS-LM model, which is widely used to analyze the interaction between the goods market and the money market in macroeconomics.

Changes in the money supply directly impact the LM function. An increase in the money supply will shift the LM function to the right, indicating a lower equilibrium interest rate for any given level of income or output. This is because a higher money supply increases the supply of real money balances, leading to a decrease in the interest rate required to equate money demand and money supply. Conversely, a decrease in the money supply will shift the LM function to the left, indicating a higher equilibrium interest rate.

The LM function has certain limitations in macroeconomic analysis. Firstly, it assumes a fixed relationship between the interest rate and the level of income or output, neglecting other factors that may affect these variables. Secondly, it assumes a static money market equilibrium, overlooking the dynamic nature of real-world economies. Additionally, the LM function does not consider factors such as inflation, expectations, and financial market developments, which can significantly impact the relationship between the interest rate and income or output. Therefore, while the LM function is a useful tool in macroeconomic analysis, it should be used in conjunction with other models and considerations to provide a comprehensive understanding of the economy.