Question

Question 3

C) What happens to the LM if Ms↑ while Y is constant? Show this using two graphs: 1) the money market graph and 2) the LM graph.

d) Assume that the Fed knows both Yn and the location of the IS curve. Show where the Fed will set i

Answer 1

c).

“LM” curve shows the positive relation between “r” and “Y” in which the money market is in equilibrium. So, initially “LM1” be the initial curve. So, in the equilibrium “r=r1” and “Y=Yn”. Now, as the “money supply” increases, => “Ms1” shift to “Ms2”, => given the “money demand” curve “Md(Yn)” the equilibrium rate of interest decreases to “r2”, => as the level of income remain same, => the “LM”
curve shift downward to “LM2” with the same income “Yn”. Consider the following fig.

d).

As we know that the IS curve shows the negative relationship between “r” and “Y” in which the output market is in equilibrium. So, if the full employment level of output is “Y=Yn”, => the rate of interest should be such that the output is in equilibrium. So, mathematically if the equation of “IS” curve is “r = r(Y), dr/dY < 0. So, the rate of interest should be, r=r(Yn). Consider the following fig.