Changes in the money supply also shift the LM curve. It incorporates both the dependence of spending on the real interest rate and the fact that, in the short run, real GDP equals spending. The IS curve is shown in Figure The IS curve is downward sloping: as the real interest rate increases, the level of spending decreases. The dependence of spending on real interest rates comes partly from investment.
As the real interest rate increases, spending by firms on new capital and spending by households on new housing decreases.
Consumption also depends on the real interest rate: spending by households on durable goods decreases as the real interest rate increases.
The connection between spending and real GDP comes from the aggregate expenditure model. Given a particular level of the interest rate, the aggregate expenditure model determines the level of real GDP. Now suppose the interest rate increases. This reduces those components of spending that depend on the interest rate.
In the aggregate expenditure framework, this is a reduction in autonomous spending. The equilibrium level of output decreases. Combining the discussion of the LM and the IS curves will generate equilibrium levels of interest rates and output. Note that both relationships are combinations of interest rates and output. Solving these two equations jointly determines the equilibrium.
This is shown graphically in Figure This just combines the LM curve from Figure Comparative statics results for this model illustrate how changes in exogenous factors influence the equilibrium levels of interest rates and output.
For this model, there are two key exogenous factors: the level of autonomous spending excluding any spending affected by interest rates and the real money supply. We can study how changes in these factors influence the equilibrium levels of output and interest rates both graphically and algebraically. Variations in the level of autonomous spending will lead to a shift in the IS curve, as shown in Figure If autonomous spending increases, then the IS curve shifts out.
The output level of the economy will increase. Interest rates rise as we move along the LM curve, ensuring money market equilibrium. One source of variations in autonomous spending is fiscal policy. Autonomous spending includes government spending G. Thus an increase in G leads to an increase in output and interest rates as shown in Figure Variations in the real money supply shift the LM curve, as shown in Figure If the money supply decreases, then the LM curve shifts in.
This leads to a higher real interest rate and lower output as the LM curve shifts along the fixed IS curve. We can represent the LM and IS curves algebraically. For simplicity, suppose that the inflation rate is zero, so the real interest rate is the opportunity cost of holding money.
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Conclusion This paper has shown that the LM curve could be downward sloped if the rate of interest on money specifically liquid deposits is sufficiently flexible.
Three policy implications follow directly. Google Scholar R. Article Google Scholar B. Thus, a low price level induces consumers to save, which in turn drives down the interest rate. A low interest rate increases the demand for investment as the cost of investment falls with the interest rate.
Thus, a drop in the price level decreases the interest rate, which increases the demand for investment and thereby increases aggregate demand. The third reason for the downward slope of the aggregate demand curve is Mundell-Fleming's exchange-rate effect. Recall that as the price level falls the interest rate also tends to fall.
When the domestic interest rate is low relative to interest rates available in foreign countries, domestic investors tend to invest in foreign countries where return on investments is higher. As domestic currency flows to foreign countries, the real exchange rate decreases because the international supply of dollars increases. A decrease in the real exchange rate has the effect of increasing net exports because domestic goods and services are relatively cheaper.
Finally, an increase in net exports increases aggregate demand, as net exports is a component of aggregate demand. Thus, as the price level drops, interest rates fall, domestic investment in foreign countries increases, the real exchange rate depreciates, net exports increases, and aggregate demand increases.
There is another major model that is useful for explaining the nature of the aggregate demand curve. This model is called the IS-LM model after the two curves that are involved in the model. The IS-LM model exists in a plane with r, the interest rate, on the vertical axis and Y, being both income and output, on the horizontal axis.
The IS-LM model has the same horizontal axis as the aggregate demand curve, but a different vertical axis. The IS curve describes equilibrium in the market for goods and services in terms of r and Y.
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