An explanation for the slope of the IS curve is that as the interest rate increa

Question

An explanation for the slope of the IS curve is that as the interest rate increases, the quantity of investment and this shifts the expenditure function thereby decreasing income. Decreases; downward When the LM curve is drawn, the quantity that is held fixed is: the real money supply According to the theory of liquidity preference, tightening the money supply will nominal interest rates in the short run, and, according to the Fisher effect, tightening the money supply will nominal interest rates in the long run. increase; decrease An explanation for the slope of the LM curve is that as: income rises, money demand rises, and a higher interest rate is required. Using the IS LM analysis, if the LM curve is not horizontal, the multiplier for an increase in government spending is for an increase in government purchases using the Keynesian-cross analysis. smaller than the multiplier If the demand for real money balances does not depend on the interest rate, then the LM curve: is vertical.

Explanation / Answer

(1)

As interest rate increases, investment decreases (because borrowing becomes costlier), which shifts expenditure function (Y = C + I + G + NX) downwards, reducing income.

(2)

LM curve is drawn on the assumption that supply of money is held unchanged by Central Bank.

(3)

Lower money supply will increase nominal interest rate in short run, and will decrease nominal interest rate in long run.**
**Explained: Fisher effect says:

Nominal interest rate = Real interest rate + Inflation rate

Lower (tighter) money supply in short run will lower inflation. So, in long run, nominal interest rate will come down as inflation decreases.

(4)

As income increases, demand for money also increases (because people consume more, increasing transactions demand for money), and a higher interest rate is required. So LM curve slopes upwards.

(5)

Keynesian-cross multiplier = 1 / MPC

IS-LM Multiplier = 1 / (MPC + MPM [Marginal propensity to import]) < (1 / MPC)

So, IS-LM multiplier is smaller.

(6)

A vertical LM curve means that demand for money is independent of interest rate - it's completely insensitive to changes in interest rate.

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