Question

Explain how the change in a monetary variable could lead to a change in the real GDP in the LM-IS equilibrium?

Answer 1

Change in monetary variable is the change in money supply through which interest rates are adjusted. This change in money supply affects the LM curve keeping the IS curve unchanged. When the central bank increases the money supply, the LM curve shifts outward. That is when central bank injects more money in the economy, the consumption expenditure increases, aggregate demand increases which inturn raises the aggregate output. This increases the real GDP. Thus, with an increase in money supply, equilibrium GDP increases and equilibrium interest rate decreases.

A decrease in money supply contracts the economy. When central bank contracts the money supply, the LM curve shifts inward. Consumption expenditure falls which leads to a fall in aggregate demand. This inturn decreases the aggregate output and further the real GDP falls. Since, money supply is reduced, equilibrium interest rate increases and equilibrium real GDP falls.