Question

How can the Fed influence the location of the LM curve and the interest rate?

To help answer this question, assume that the demand for real balances is given by

(1) (M/P)d = 0.5Q ‑40i

and that money supply is initially fixed at

(2) (M/P)s = 400. (since prices are fixed you may assume P=1).

If money supply were increased to 500, and real output Q were constant at

(3) Q = 1600,

How would the intercept of the LM curve change? What would be the nominal rate of interest ?

Answer 1

M_d = 0.5Q - 40i

for LM curve M_d = M_s

M_s = 0.5Q - 40i

i = [Q/80] - [M_s/40]

when Ms = 400 : intercept = -10 , i = 10

when Ms = 500 : intercept = -12.5 , i = 7.5