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Himanshu Kulshreshtha
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Asked: 2024-01-17T12:10:56+05:30

Interpret the slope of an LM curve. What will happen when there is a decrease in money supply? Explain with the help of a diagram.

Analyze the LM curve’s slope. When the amount of money in circulation declines, what will happen? Use a diagram to assist you explain.

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    1. Elite Author

      Interpretation of the Slope of the LM Curve

      The LM curve, part of the IS-LM model in macroeconomics, represents the relationship between the interest rate and the level of income that equates the demand for money with the supply of money. The slope of the LM curve is crucial for understanding this relationship.

      1. Positive Slope of LM Curve: The LM curve typically has a positive slope, indicating that higher levels of income lead to higher interest rates. This is because, as income increases, the demand for money for transaction purposes increases. To maintain money market equilibrium, the interest rate must rise to equate the increased demand for money with the fixed money supply.

      2. Elasticity of Money Demand: The steepness of the LM curve depends on the elasticity of the demand for money. A more elastic demand for money leads to a flatter LM curve, as small changes in the interest rate lead to large changes in the quantity of money demanded. Conversely, a less elastic demand for money results in a steeper LM curve.

      Effect of a Decrease in Money Supply

      A decrease in the money supply shifts the LM curve to the left.

      1. Leftward Shift of LM Curve: When the money supply decreases, the LM curve shifts leftward because, at each income level, a higher interest rate is now required to equate the reduced money supply with money demand.

      2. Higher Interest Rates: The leftward shift of the LM curve leads to higher interest rates at each level of income. This is because the reduced money supply increases the cost of holding money, leading to an increase in interest rates to maintain money market equilibrium.

      3. Diagram Explanation: In a diagram with interest rate on the vertical axis and income on the horizontal axis, the original LM curve shifts to the left. The new equilibrium point, where the LM curve intersects the IS curve, will be at a higher interest rate and potentially a lower level of income, depending on the shape and position of the IS curve.
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      Conclusion

      The positive slope of the LM curve reflects the relationship between income and interest rates in the money market. A decrease in the money supply shifts the LM curve leftward, leading to higher interest rates and potentially lower income in the short run. This graphical analysis is crucial in understanding the impact of monetary policy on the economy.

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