Question

* The derivation of the LM curve assumes that M^S is exogenous. But suppose instead that the Central Bank has some target interest rate ¯r and that it adjusts M^S to keep r always equal to r.

(a) With this policy, what is the slope of the LM curve?

(b) With this policy, what is the slope of AD curve?

Answer 1

LM curve will be horizontal. This is because the rate of interest will always be fixed at the target level which implies that in the asset market, money supply is always adjusted to maintain the same rate of interest.

AD curve will be relatively inelastic. Interest rate is always fixed which means there is no interest rate effect that is responsible for downward sloping aggregate demand function. Foreign exchange effect and wealth effect are still effective which means aggregate demand is not entirely vertical.