Monetary policy and the LM curve: the consequences on short-term equilibrium.

We recall that, for any given level of income, a change in the money supply alters the interest rate that guarantees the equilibrium of the money market, causing the shift of the LM curve. The IS-LM model shows how a shift in the LM curve affects income and the interest rate.

Consider an increase in the money supply.

An increase in M causes an increase in real money balances M/P, since, in the short run, the price level P is fixed. According to the theory of liquidity preference, for any given level of income an increase in real money balances causes a lowering of the interest rate and, therefore, the LM curve shifts downwards, as shown in the figure. The equilibrium shifts from point A to point B: the increase in the money supply causes a decrease in the interest rate and an increase in the level of income.

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