Question

On an IS‐LM diagram, show the effects of a decrease in money demand.

a. If the government did not intervene, what would happen to output and the interest rate in the short run? What would happen in the long run?

b. If the government did intervene, using monetary policy to stabilize output, would the Fed use expansionary or contractionary monetary policy? How would you show that on the graph?

Answer 1

a. A decrease in money demand shifts the LM curve to the left in the short run. This moves the economy from point A to point B as shown in the figure. The interest rate rises from r to r1 and output declines from y to y1. The rising interest rates dicourages investments which leads to fall in output.

However, in the long run, the point B shows the level of output that is lower than the full employment level, A. Due to this, producers will start utilising the un used capacity in the economy. Supply starts increasing and prices fall. Due to this, real balances with people will rise and LM curve will shift to its original position, restoring the equilibrium at A in the long run.

b. In this case, the output is below the full employment level. Hence, the Fed will use the expansionary monetary policy. The expansionary monetary policy consists in reducing the interest rates and increasing the money supply. This will shift the LM curve to the right and restore the original equilibrium in the economy.