Question

5. Discuss, using the IS-LM model, what happens to interest rates as prices change along a 

given AD schedule.

Answer 1

If the nominal money supply, M, remains constant, a decrease in the price level causes real money balances, M/P, to increase, and the LM curve to shift to the right. The interest rate is falling to encourage demand for real money balances because there is an excess supply of them. The decrease in interest rates leads to an increase in private spending as well (investment).