Answer to Question #222952 in Macroeconomics for katrichie

Question

(a) Use appropriate diagrams and explain how the LM curve is derived. (10)

(b) Use appropriate diagrams explain under what circumstances monetary policy is

(i) Completely ineffective (5)

(ii) Most effective (5)

Answer 1

(a)  The LM curve, where "L" stands for liquidity and "M" for money, is a graph of real income, Y, and the real interest rate, r, in which the money market is in equilibrium (i.e. real money supply equals real money demand). The LM curve's graphical derivation is shown in the diagram below.

The money market equilibrium is depicted on the left side of the graph for a specific level of Y. When Y = Y0, for example, the equilibrium real interest rate is 5%. The LM curve is shown on the right-hand side of the graph. The real interest rate is plotted on the vertical axis, while real income (GDP) is plotted on the horizontal axis. For a given real interest rate and income pair, each point on the LM curve reflects a money market equilibrium (r, Y). The dark (middle) dot on the LM curve, for example, represents the money market equilibrium at (r=5%, Y=Y0).

The money demand curve changes up and right as income rises, Y1 > Y0, and a new equilibrium is reached when r = 7%. The blue (upper) dot on the LM curve represents this equilibrium. At a lower level of income, Y2 Y0, the money demand curve changes down and left, resulting in a new equilibrium at r = 3%. The red (lower) dot on the LM curve represents this equilibrium.

The LM curve is an upward sloping curve in the graph with r on the vertical axis and Y on the horizontal axis, as seen in the preceding analysis. Every point on the LM curve represents a position where the real money supply (M/P) and the real money demand (M/D) connect (Ld). The LM curve will vary if the variables in the money-supply/money-demand diagram that we maintain constant, other than Y, change.

M/P and e are the variables in question. If M/P rises but projected inflation remains constant, r falls in the money market, and the LM curve changes down and right. In the same way, as projected inflation rises, real money demand declines, lowering the interest rate and shifting the LM curve down and to the right. The LM curve is functionally represented as

The (+) sign indicates that an increase in the variables shifts the LM curve down and to the right.

(a)  (i) Through monetary policy, the government can influence investment, employment, output, and income as shown in figure 1. The monetary authority does this by increasing or lowering the money supply. An expansionary monetary policy is one in which the money supply is raised. Shifting the LM curve to the right demonstrates this. A contractionary monetary policy is one in which the money supply is reduced. Shifting the LM curve to the left demonstrates this. Assume that the economy is at point E, with OY income and OR interest rate. Given the IS curve, an increase in the money supply by the monetary authority changes the LM curve to the right to LM1. As a result, the interest rate is reduced from OR to OR1, resulting in increased investment and national income. As a result, national income increases from year to year.

(ii) The efficiency of monetary policy (MP) is also affected by the economy's cyclical situation. As shown in Fig. 10.13, when Y and r are both high, a given shift of the LM curve owing to an increase in the money supply will have a bigger effect on Y than when they are both low. When the LM curve is vertical, as seen by relatively greater levels of r and Y, MP is more effective than when it is flat, as shown in Fig. 10.13. As a result, MP is most effective (and FP is least effective) when the economy has a high r, Y level and can use nearly all of its money supply to support financial transactions, i.e., to support Y.

The success of the two policies is determined by how they interact.