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Using the liquidity preference model, graphically illistrate the effect of an increase in the money supply...

Using the liquidity preference model, graphically illistrate the effect of an increase in the money supply (ceteris paribus)

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Answer #1

In the liquidity preference model, money market equilibrium is obtained by equality of demand for real balances (demand for money) and supply of money.

An increase in money supply shifts the money supply curve rightward, decreasing real interest rate and ncreasing quantity of money ceteris paribus. In following graph, real interest rate (r) and quantity of money (M) are measured vertically and horizontally, respectively. MD0 & MS0 are initial money demand & money supply curves (Money supply is fixed by Central Bank, therefore supply curve is vertical), intersecting at point A with initial interest rate r0 & quantity of money M0. As money supply increases, MS0 shifts right to MS1, intersecting MD0 at point B with lower interest rate r1 & higher quantity of money M1.

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