Question

2 LM model: thought experiment:

Use money market equilibrium to graphically show how LM curve shift in following cases:

(1) the Fed decide to sell government bonds this year;

(2) the public’s inflation expection rises because one of the Fed officials told the media that the Fed will increase the money supply significantly next year in 2019.

(3) real GDP increases because technology improves.

Answer 1

1) When the Fed decides to sell government bonds this year, the money supply decreases in the economy represented by a leftward shift in the money supply curve, which leads to higher interest rates. Producing same output at higher interest rates leads to a leftward shift in the LM curve.

2) When the public’s inflation expectation rises because one of the Fed officials told the media that the Fed will increase the money supply significantly next year in 2019, then the money supply will increase in the economy, represented by a rightward shift in the money supply curve, which leads to the lower interest rate. Producing same output at lower interest rates leads to a rightward shift in the LM curve.

3) When real GDP increases because technology improves, then the money demand increases in the economy, represented by a rightward shift in the economy, leading to higher interest rates. Producing same output at higher interest rates leads to a leftward shift in the LM curve.