Question

The derivation of the LM curve assumes that MS is exogenous. But suppose instead that the Central Bank has some target interest rate ¯r and that it adjusts MS to keep r always equal to ¯r.

(a) With this policy, what is the slope of the LM curve?

(b) With this policy, what is the slope of AD curve?

Answer 1

(a) With the policy of keeping interest rate is fixed at -​​​​-r, the slope of LM curve will be horizontal. Now the question is why it is horizontal? In general we get that change of r and Y so that money supply is fixed we get money demand is equal money supply at that level. It means to keep money supply supply fixed we get different combination of r and Y so that money demand is equal money supply. Now if want to keep interest rate fixed there should be any level of money supply at that interest rate. It means money supply has to be full flexible at that interest rate so that any combination of Y and that particular r we get the situation money market equilibrium. So for keeping interest rate fixed at r = -​​​​​r the money supply will be horizontal at that particular police fixed interest rate.

b). With this policy of keeping interest rate fixed the AD curve shape will be vertical. In general we get downward sloping AD curve when central bank targets money supply fixed. In normal cases when price level is M/P is higher because M​​​​​​s is fixed and at fixed money supply if price level p is lower M/P will be higher and due to this LM curve shifts right and as a result Y also increases. Because AD is all combination of P and Y. At lower P , Y will be higher.

Now when M​​​​​​s is flexible i.e money supply can change there no need to change price level. At particular level of Y there can be any price level because money supply can change according to that we get money market equilibrium and goods market equilibrium. It means there will be an unique level of Y that clears money market and makes planned and actual expenditure equal. The level of Y is where horizontal LM curve and IS curve intersect. Therefore we can say AD curve will be vertical at that particular level of Y.