Unformatted text preview: LM curve is drawn for a given supply of real money balances. Decrease in the supply of real money balances shift the LM curve upward. Increases in the supply of real money balances shift the LM curve downward In chapter 9 we derive the aggregate demand curve from the quantity theory of money by assuming that velocity V is constant. The assumption of constant velocity is based on the assumption that the demand for real money balances depends only on the level of income. However, we have noted that demand for real money balances also depends on the interest rate. When people respond to a higher interest rate by holding less money, each dollar they do hold must be used more often to support a given volume of transactions that is, the velocity of money must increase. We can write this as MV(r) = PY. Velocity is positively related to the Page 33 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 interest rate. Because an increase in the interest rate raises the velocity of money, it raises the level of income for any given money supply and price level, hence the positive relationship between the interest rate and income. Also, for any given interest rate and price level, the money supply and the level of income must move together, thus changes in M shift the LM curve. In conclusion, the IS LM model takes fiscal policy, G and T, monetary policy M, and the price level P as exogenous. Given these, the IS curve provides the combinations of r and Y that satisfy the equation representing the goods market, and the LM curve provides the combinations of r and Y that satisfy the equation representing the money market. The equilibrium of the economy is the point at which the IS curve and the LM curve cross. In other words, at this point, actual expenditure equals planned expenditure, and the demand for real money balances equals the supply. Chapter 11 How fiscal policy shifts the IS curve and changes the short run equilibrium: Changes in government purchases: the government purchases multiplier tells us that a positive change in G raises the level of income at any given interest rate by ΔG = (1 – MPC). This shifts IS to the right by this amount, increasing both income and the interest rate. The increase in gover...
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 Fall '10
 Henriques
 Macroeconomics

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