Question 1

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

Accepted Answer

When the central bank injects more money, it creates excess liquidity in the economy. At the current interest rate, people do not want to hold all this extra money. To restore balance between money supply and demand, the interest rate must fall. This causes the LM curve to shift rightward, reflecting a new equilibrium in the asset market.

Question 2

Why does the IS curve remain unchanged during expansionary monetary policy?

Accepted Answer

The IS curve represents equilibrium in the goods market, which is not directly affected by changes in the money supply. Expansionary monetary policy operates first in the asset market, shifting the LM curve. Since the goods market conditions have not changed, the IS curve stays in its original position while the economy moves to a new equilibrium point.

Question 3

How does lower interest rates from monetary expansion encourage investment spending?

Accepted Answer

Lower interest rates make borrowing less expensive for firms. When financing costs decrease, investment projects become more attractive. For example, a logistics company may decide to expand its vehicle fleet when interest rates fall. As firms increase investment spending, aggregate demand rises and businesses respond by increasing production, contributing to higher income levels.

Question 4

What is the relationship between money supply and interest rates in the IS-LM framework?

Accepted Answer

When the central bank increases the money supply, excess liquidity develops in the economy. People and businesses find themselves holding more money than needed for transactions. As they adjust their holdings, interest rates move downward. This inverse relationship between money supply and interest rates is central to how expansionary monetary policy stimulates economic activity through lower borrowing costs.

Question 5

How does expansionary monetary policy affect equilibrium income in the short run?

Accepted Answer

Expansionary monetary policy shifts the LM curve rightward, creating a new equilibrium where interest rates fall and income rises. Lower interest rates encourage firms to borrow and invest more, boosting aggregate demand. The economy moves from the original equilibrium point to a new point with higher output and lower interest rates, demonstrating the expansionary impact of increased money supply.

Question 6

What is the chain of events connecting money supply changes to spending decisions?

Accepted Answer

A change in the money supply begins in the asset market but influences spending decisions throughout the economy. When the central bank increases money supply, interest rates fall, making borrowing cheaper. Lower borrowing costs encourage firms to invest and households to spend more. This increased spending raises aggregate demand, prompting businesses to increase production and contributing to higher overall income levels.

Question 7

How does expansionary monetary policy compare to contractionary monetary policy in the IS-LM model?

Accepted Answer

Expansionary monetary policy increases the money supply, shifting the LM curve rightward to lower interest rates and raise income. Contractionary monetary policy does the opposite, decreasing money supply and shifting the LM curve leftward to raise interest rates and reduce income. Both policies operate through the asset market first, but produce opposite effects on equilibrium interest rates and output levels.

Expansionary Monetary Policy in the IS-LM Model

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