Question 1

What happens to the LM curve when the central bank increases the money supply?

Accepted Answer

When the central bank increases the nominal money supply, people hold more cash than needed at the current interest rate. They purchase bonds to earn returns on idle cash, driving bond prices up and interest rates down. Since lower interest rates apply at every income level, the entire LM curve shifts to the right, reflecting easier monetary conditions.

Question 2

How does a decrease in money supply affect the LM curve?

Accepted Answer

When the central bank reduces the money supply, cash becomes scarce and people hold less money than desired at the existing interest rate. They sell bonds to increase cash balances, causing bond supply to rise and interest rates to increase. Higher interest rates at each income level shift the LM curve to the left.

Question 3

Why does the entire LM curve shift rather than just moving along it?

Accepted Answer

The LM curve represents equilibrium combinations of income and interest rates in the money market. When money supply changes, it alters the equilibrium interest rate at every income level simultaneously. This causes the entire curve to shift horizontally rather than tracing movement along the existing curve.

Question 4

What role does the asset market play in LM curve shifts?

Accepted Answer

The asset market determines how people adjust their holdings of money versus financial assets when money supply changes. When excess cash exists, people buy bonds, lowering interest rates. When cash is scarce, people sell bonds, raising interest rates. These asset market adjustments drive the interest rate changes that shift the LM curve.

Question 5

How do interest rate changes from money supply adjustments affect business financing?

Accepted Answer

When the central bank increases money supply, interest rates fall, making short-term loans less expensive for businesses. Companies that regularly use short-term financing benefit from lower borrowing costs. Conversely, when money supply decreases and interest rates rise, business financing becomes more costly, affecting investment decisions.

Question 6

What is the relationship between money supply, interest rates, and money market equilibrium?

Accepted Answer

Money market equilibrium occurs when the quantity of money people want to hold equals the money supply available. Changes in money supply alter the equilibrium interest rate needed to balance the market. An increase in money supply lowers equilibrium interest rates, while a decrease raises them, with these changes reflected by LM curve shifts.

Question 7

Why do people rush to buy or sell bonds when money supply changes?

Accepted Answer

When money supply increases, people hold excess cash earning no returns, so they buy bonds to earn interest. When money supply decreases, people need more cash for transactions, so they sell bonds to raise cash. This bond market activity is the mechanism through which money supply changes translate into interest rate adjustments.

Shift of the LM Curve I

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