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Using IS-LM analysis, illustrate the effect of a decrease in the money supply on equilibrium interest...

Using IS-LM analysis, illustrate the effect of a decrease in the money supply on equilibrium interest rate and output. Explain what you are illustrating in your diagram and why the curve(s) are moving.

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Answer #1

When the money supply is decreased the for a given level of income/output, interest rate rises. This happens because with the decline in money supply people will start to withdraw money from their speculative balances to finances their transaction needs. To keep the money market in equilibrium, the interest rate will rise from r1 to r2.

Increase in the interest rate will result in the decline in the investment level. This happens because, with an increased interest rate, borrowing for the purchase of machinery or for building plants becomes expensive for the firms. The decline in the investment causes a decline in the income/output in the economy from y1 to y2.

So, a decrease in the money supply causes interest rate to rise and income/output to decline in the economy.

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