Monetary Policy

Monetary Policy

Changes in money supply shifts the LM curve. When an expansionary monetary policy is adopted, for example, the LM curve shifts right causing interest rate to fall and income to rise.

The increase in money supply, by creating an excess money supply causes interest rate to fall. The fall in interest rate stimulates investment and this therefore results in an increase in income. A new equilibrium is achieved when the fall in interest rate and the rise in income jointly increase money demand by an amount equal to the increase in money supply. This equilibrium occurs at the point where the new LM curve intersects the IS curve. A decline in money supply has the opposite effect.

Monetary policy is effective provided:

Md must be interest inelastic (insensitive to changes in interest rate- LM steep); and

Investment must be responsive to changes in interest rate (IS relatively flat)