Let us make an in-depth study of Money Supply on the LM-Curve.

Effect Of Money Supply On Real Interest Rates For A
Money Supply Vs Interest Rates

The interest sensitivity of the money supply can now be shown in terms of the IS-LM curve model.

The study determined the effect of the interest rates on the supply of real estate finance and found out that more people are likely to borrow money when the interest rate is lower as doing so will cost them less than at another time. It was also evident that when the interest rate is higher, borrowing becomes more expensive and slows.

Effect Of Money Supply On Real Interest Rates For A

Fig. 20.5 shows the supply and demand curves for money balances M.

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At the original interest rate, i$′, real money demand has increased to level 2 along the horizontal axis while real money supply remains at level 1. This means that real money demand exceeds real money supply and the current interest rate is lower than the equilibrium rate.
The money demand curve shifts to the right. The money supply curve remains in place but interest rates rise along it, reducing private investment. The money supply curve shifts to the left since with less deposits, banks have to reduce their lending activity. Interest rates fall and money demand falls along the investment demand curve.
Lastly, the Fed can affect the money supply by conducting open market operations, which affects the federal funds rate. In open operations, the Fed buys and sells government securities in the open.
The Fisher Effect is an economic theory created by economist Irving Fisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher Effect states that.

With an initial income level Y₀, the demand-for-money curve is M(Y₀).

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With an initial money supply M₀ we hold P constant throughout this analysis. So we do not draw a distinction between nominal balance and real balance. The interest rate is r₀. Now suppose income rises, due to a rightward shift of the IS curve. Then the demand curve in Fig 20.5 shifts up to M(Y₁), and with a money supply fixed at M₀, the interest rate will rise to i₁.

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But if the money supply is responsive to interest rate changes, the money supply function through the initial equilibrium point i₀, M₀ (Y₀) will be the positively sloped supply function M(i – i_d) in Fig. 20.5. In this case, the increased demand for money leads to an increase in supply equal to M₁ – M₀ as the interest rate rises to i₂ instead of i₁.

Thus, the interest elasticity of the money supply reduces the increase in i (from i₁ – i₀ to i₂ – i₀) needed to maintain money market equilibrium with a given increase in Y, from Y₀ to Y₁, in Fig. 20.5.

Thus with an interest-sensitive money supply, the slope of the LM curve is flatter than otherwise. This is shown in LM diagram of Fig. 20.6. At the initial interest rate i₀, the real money supply is equal to M(i₀) in the southwest quadrant. If the interest rate rises to i₁, with the money supply fixed at M(i₀), the level of income must rise to Y₁ to maintain money market equilibrium.

The interest rate increase reduces the speculative and transactions demand for money. Now it is not necessary for money supply to support an increase in Y within the constraint of a given M.

If the money supply is not fixed, but is a function of the interest rate i:

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M = M(i); M’ > 0,

then an increase in the interest rate from i₀ to i₁ shifts the money supply out from M(i₀) to M(i₁) in Fig. 20.6. This increase in money supply will support an increase in income to Y₂ as opposed to Y₁. Thus, the LM curve with an interest-sensitive money supply looks like L₁M₁ in Fig. 20.6 — flatter than L₀M₀ — which assumes a fixed real money supply.

We can now derive the modified expression for the slope of the LM curve with an interest- sensitive money supply by using the equilibrium condition in the money market. The demand for money can be expressed as either

Effect Of Money Supply On Real Interest Rates For A

Money Supply Vs Interest Rates

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