Question

Use the IS-LM model of a closed economy to explain and graphboth the short run effects and the long-run effects of an increase in the money supply on national income, interest rate, investment, and the price level.

Answer 1

In short run we see that an increase in money supply shifts the LM curve to the right ie the new equilibrium is B . this leads to a fall in interest rate and the output increases ie the output is more thn the full employment. this happens because the interest rate has fallen . as we know that interest and investment are inversely related so any fall in interest rate would give rise to investments(explained by IS curve) and an increase in investment would lead to an increase in output or income (Y) .

In long run, now that we have an increased level of output or national income which is more than the natural level of employment , the prices tend to rise( they fall when output is less than the full employment level ). This rise in price will lead to a reduction in real money supply ie M/P ratio which is the LM curve equation reduces when P increases . so this leads to shift of LM curve back from B to A and this leads to the economy returning at full or natural level of employment