Effect of Money Supply on the LM-Curve (With Diagram)

Let us make an in-depth study of Money Supply on the LM-Curve.

The interest sensitivity of the money supply can now be shown in terms of the IS-LM curve model.

Fig. 20.5 shows the supply and demand curves for money balances M.

With an initial income level Y₀, the demand-for-money curve is M(Y₀).

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With an initial money supply M₀ we hold P constant throughout this analysis. So we do not draw a distinction between nominal balance and real balance. The interest rate is r₀. Now suppose income rises, due to a rightward shift of the IS curve. Then the demand curve in Fig 20.5 shifts up to M(Y₁), and with a money supply fixed at M₀, the interest rate will rise to i₁.

But if the money supply is responsive to interest rate changes, the money supply function through the initial equilibrium point i₀, M₀ (Y₀) will be the positively sloped supply function M(i – i_d) in Fig. 20.5. In this case, the increased demand for money leads to an increase in supply equal to M₁ – M₀ as the interest rate rises to i₂ instead of i₁.

Thus, the interest elasticity of the money supply reduces the increase in i (from i₁ – i₀ to i₂ – i₀) needed to maintain money market equilibrium with a given increase in Y, from Y₀ to Y₁, in Fig. 20.5.

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Thus with an interest-sensitive money supply, the slope of the LM curve is flatter than otherwise. This is shown in LM diagram of Fig. 20.6. At the initial interest rate i₀, the real money supply is equal to M(i₀) in the southwest quadrant. If the interest rate rises to i₁, with the money supply fixed at M(i₀), the level of income must rise to Y₁ to maintain money market equilibrium.

The interest rate increase reduces the speculative and transactions demand for money. Now it is not necessary for money supply to support an increase in Y within the constraint of a given M.

If the money supply is not fixed, but is a function of the interest rate i:

M = M(i); M’ > 0,

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then an increase in the interest rate from i₀ to i₁ shifts the money supply out from M(i₀) to M(i₁) in Fig. 20.6. This increase in money supply will support an increase in income to Y₂ as opposed to Y₁. Thus, the LM curve with an interest-sensitive money supply looks like L₁M₁ in Fig. 20.6 — flatter than L₀M₀ — which assumes a fixed real money supply.

We can now derive the modified expression for the slope of the LM curve with an interest- sensitive money supply by using the equilibrium condition in the money market. The demand for money can be expressed as either

Effect of Money Supply on the LM-Curve (With Diagram) | Supply of Money