Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

M . LM
2
shows the money market 
equilibrium of the increase in the supply of money. 
1
E
2
E
1
i
2
i
0
0
Income / Output
1
E
1
M
P
2
M
P
1
LM
2
LM
Y
L Y
RealMoneyBalance
(A)
(B)
InterestRate

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Thus an increase in the supply of real balance shift the LM 
curves down and to the right which results a fall in the rate of 
interest. However, a fall in the interest affects goods market through 
investment demand. The effect of shift of LM curve on equilibrium 
income and interest in the money market and goods market is 
brought out in the following diagram. 
 
 
FIGURE 8.8: MONETARY EXPANSION AND IS CURVE 
 
At initial supply of money (before the monetary expansion) 
the IS 
– LM intersection gives the equilibrium income and interest 
rate as Y
1
and i
1
respectively with E
1
as equilibrium point. 
As a result of monetary expansion, the LM curve shift from 
LM
1
to LM
2
. The money market equilibrium takes place at lower 
rate of interest shown as E
2
in the diagram. As a result private 
sector investment increases and hence income and output also 
increases. The increase in income raises demand for money and 
rate of interest. This is shown in the movement from E
1
to E
2
, where 
LM
2
intersect the IS curve. 
Thus an increase in the money supply has finally resulted an 
increase in level of output and decrease in rate of interest (income 
from Y
1
to Y
2
and interest falls from i
1
to i
2
). 
The transaction mechanism through which increase in money 
supply increases the output is shown below. 
1