Question

The LM curve is steeper the ______ the interest sensitivity of money demand and the ______ the effect of income on money demand. (This is a difficult question. If you do not have the answer, pls try your best guess, considering also going by elimination. Hint: Draw two LM curves with different slopes, one flatter and one steeper, and then compare the interest rate change for a given IS shift at the initial income level and the income change for the same IS shift at the initial interest rate level). a. greater; greater b. greater; smaller c. smaller; smaller d. smaller; greater

Answer 1

The correct option is,  (d) smaller, greater.

• The LM curve is steeper the smaller the interest sensitivity of money demand and the greater the effect of income on money demand.

What does a steeper LM curve mean?

• The LM curve will be steeper if the income-elasticity of the demand for money is higher and the interest-elasticity is lower.
• The LM curve is virtually vertical when the demand for money is generally indifferent to the interest rate.

What causes the LM curve to shift?

• The LM curve shifts right as a result of monetary stimulation, or boosting the money supply, leading to higher output and lower interest rates.
• The IS curve is shifted to the right by fiscal stimulus, or boosting government spending and/or lowering taxes, which raises interest rates while driving up output.

What is income sensitivity of money demand?

• The greater the interest rate, as the minus sign suggests, the more likely people are to invest their money rather than have it available for consumption.
• The income sensitivity of real money demand and the interest sensitivity of real money demand are the two variables that are regulated by sensitivity coefficients.

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