3.2 The shift of the LM curve in a closed economy

When deriving the LM curve, we assumed that both the money supply M and the price level P – and thus also the relationship between both variables, the real money supply MP – are fixed.

However, changes in the real money supply, for example by inflation or monetary policy measures, shift the LM curve.

An increase in the nominal money supply M thus has the same effect as a decrease in the price level P, the real money supply MP increases.

If, for example, the nominal money supply is increased and the price level P remains constant, then the real money supply increases. For each income level, the interest rate i, which enables an equilibrium on the money and financial market, is now lower and as a result the LM curve shifts downwards.

Similarly, a reduction in the money supply, whether caused by a decrease in the nominal money supply M or by an increase in the price level P (inflation), leads to an increase in the interest rate i. for every income level. Here, the LM curve shifts upwards.

In addition, the initial interest rate is movable between 2 and 10, so that the effects of a changing interest rate can also be observed. It can be seen that at high interest rates the sensitivity of income in regard to a money supply expansion is less than at low interest rates.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743
E-mail: Bauer@uni-trier.de
URL: https://www.cbauer.de