Question

What shape does the LM curve take when the central bank fixes the interest rate instead of money supply? How does monetary policy work in such an economy?

Answer 1

Answer - If the money supply is held constant and only the interest rates change in the economy , the LM curve is Vertical in shape because of no change in the supply of money.

The expansionary monetary policy increases the supply of money by decreasing the rates of interest , thus increasing capacity to borrow and increased consumption and investment.

On the other hand , in the contractionary policy , the reserve ratios are increased , discount rates are increased. This leads to increase in interest rates in economy. The borrowing becomes expensive and hence the money supply falls in the economy.