Answer to Question #94132 in Macroeconomics for Ria

Question

(a)Explain four factors that cause a shift in the LM curve.
(b) Using a clearly labelled diagram, discuss the effects of a contractionary monetary policy.

Answer 1

Possible shifts in the LM curve:

A change in money supply (M):

1. If the central bank (or Federal Reserve) decides to increase the money supply (by buying t bills) then the LM curve shifts right.
2. If the central bank (or Federal Reserve) decides to decrease the money supply (by selling t bills) then the LM curve shifts left.

A change in transaction technologies, ie credit cards (L):

1. If improvement in the velocity of money occurs such that people require less money to conduct all of their transactions, the LM curve will shift right (because the opportunity cost of holding money goes down because there is now an alternative).

A change in the overall price level (P):

1. If the price level rises, the LM curve shifts left. This occurs because people need more money to pay the higher prices, but the higher resulting interest rates lower the demand for money.
2. If the price level declines, the LM curve shifts right. This occurs because people need less money to pay the lower prices, and the lower interest rates increase their demand for holding money.

Effects of a Contractionary Monetary Policy

A contractionary monetary policy may result in some broad effects on an economy. The following effects are the most common for a contractionary monetary policy:

 

1. Reduced inflation

The inflation level is the main target of a contractionary monetary policy. By reducing the money supply in the economy, policymakers are willing to keep the inflation at sustainable levels and stabilize the prices in the economy.

 

2. Slow down economic growth

A contractionary monetary policy usually slows down economic growth. As the money supply in the economy decreases, individuals and businesses generally halt major investments and capital expenditures, as well as the companies slow down their production.

 

3. Increased unemployment

Another side effect of a contractionary monetary policy is a rise in unemployment. The economic slowdown and lower production cause companies to hire fewer employees. Therefore, unemployment in the economy increases.