Question

Use the IS-LM model to predict the effect of an increase in the money supply on...

Use the IS-LM model to predict the effect of an increase in the money supply on output, Y , and the real interest rate, r in the short-run.

What is the effect of this policy on these variables in the long-run? How do you know?

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Answer #1

Equilibrium interest rate is decided where IS and LM curve intersect each others.

Increase in money supply shifts LM curve to right thereby causing fall in interest rate and increasing output level.

Following is diagram:

Increase in money supply causes rightward shifts in LM curve which reduces interest rate and increases output level.

In long run, economy operates at full employment level or full potential level. Hence, Increase in money supply does not cause rise in output level. It causes rise in inflation only. Hence, real interest rate also falls due to rise in inflation rate and fall in nominal interest rate.

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