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Monetary Economics

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Introduction

Monetary Economics A Brief Introduction The IS-LM model is the best known macro model and was invented by Professors Hicks and Hansen in 1937. A change in money supply (MS) leads to a change in interest rates (RI), which in turn leads to a change in income. Points along the IS curve show equilibrium in the goods market and points along the LM curve represent equilibrium in the money market. The point of intersection determines equilibrium in the economy. The point at re is the opportunity cost of holding money- the rate of return on assets, which are direct alternatives to holding money. A doubling in the nominal quantity of money When the money supply changes, the effect is to shift the LM curve. With an increase in money supply there is a rightward shift from LM1 to LM2. ...read more.

Middle

This is in line with the theory of Neutrality of Money. Increase in desire to invest If the tastes, with regards to investment changes and the desire to invest increases at every rate of interest, this will have an effect on the Investment = Savings (IS) curve. For this to occur, savings need to increase at every rate of interest, or in other words savings are not affected by the interest rate but rather by levels of income. This means if savings are to increase the level of income needs to increase, thus shifting IS curve to the right from IS1 to IS2, creating a point of equilibrium at point B. There is also a reduction in the real quantity of money - demand for money is a function of two variables (income and rate of interest). ...read more.

Conclusion

The increase in the willingness to work will result in a higher level of output, from Y/P1 to Y/P2. This can be shown in figure 5 as labour increases from point L1 to L2. The increase in output will also shift the AS1 curve to the AS2 curve, resulting in a level of output which has increased from Y/P1 to Y/P2. The change is shown in the IS-LM model below, figure 6 by a rightward shift of the AS1 curve to AS2. The increasing output and decreasing wage rate causes the price level to fall. A lower price means expenditure is decreased and therefore the money supply increases, the change causing the shift of the LM curve from LM1 to LM2. The effect on money supply is proportional to the change in price and therefore equilibrium is attained at E2. At the new equilibrium, real interest rates have fallen from r1 to r2. Word Count 800 ...read more.

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