The LM curve tells us the interest rate that equilibrates the money market at any level of income. Yet, as we saw earlier, the equilibrium interest rate also depends on the supply of real money balances MP\frac{M}{P}. This means that the LM curve is drawn for a given supply of real money balances. If real money balances change— for example, if the Fed alters the money supply—the LM curve shifts.

We can use the theory of liquidity preference to understand how monetary policy shifts the LM curve. Suppose that the Fed decreases the money supply:

MM

3.50
25.5

This causes the supply of real money balances to fall. Holding constant the amount of income and thus the demand curve for real money balances, we see that a reduction in the supply of real money balances raises the interest rate that equilibrates the money market. Hence, a decrease in the money supply shifts the LM curve upward.

In summary, the LM curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for real money balances. The LM curve is drawn for a given supply of real money balances. Decreases in the supply of real money balances shift the LM curve upward. Increases in the supply of real money balances shift the LM curve downward.