Question

2. Show the effect of a decrease in the price level on the LM curve and explain the reasons for the changes you made. Only one graph is required. (10 pts.) Note: While only one graph is required, detailed discussion of the money market is required. If you include a graph of the money market, in your answer, it will be “graded” unless you use the OMIT option as mentioned in class.

Answer 1

Money market shows the equilibrium between demand and supply of real money balances and this is determined by rate of interest. Money supply is a real variable here because it is fixed at Ms/P where it is divided by price level

A fall in the price level will increase the purchasing power of money. This implies that real money supply increases although nominal money supply is unchanged. Money supply curve shifts right. AT the initial rate there are more excess reserves and people deposit more money when they can spend more with available cash in hand.

Banks reduce rate of interest to advance more loans so this pushes the rate of interest down. In that sense, a decrease in the price level will increase real money supply and shifts the LM curve rightwards