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Let us now see a bit more closely how monetary policy works. See Figure
The initial equilibrium at point E is on the initial LM schedule that corresponds to a real money supply . Suppose now that the nominal quantity of money is increased, for example by open market operations. Given a constant price level, the real quantity of money increases as the nominal quantity of money increases. As a result of the increase in the real quantity of money, the LM schedule shifts to LM1.
For the new schedule LM1, the equilibrium will be at point E1 with a lower rate of interest and a higher level of income.
Let us see a bit more closely how with an expansion in real money supply the economy moves from the original equilibrium at E to the new equilibrium at E1. At the initial equilibrium point, E, the increase in money creates an excess supply of money. The public tries to adjust to the excess supply of money by buying financial assets. As a result of the increase in demand, the price of financial assets rises, and thus the yields decline. The adjustment process in the assets markets is much more rapid than that in the goods market and, therefore, we move immediately to point El when the money supply increases. At E1 the money market clears and the public is holding larger quantity of real money because the interest rate has declined sufficiently. At point E1, however, there is an excess demand for goods. The decline in the interest rate, given the initial income level Y0, raises aggregate demand and thus causes inventories to run down. In response, the output expands and we start moving up the LMl schedule. As output expands, the interest rate rises (after the immediate decline in interest rate when money supply is increased) because increase in output raises the demand for money and the increase in demand for money has to be checked by higher interest rates.
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