4.2 Monetary policy

Now that the effects of fiscal policy measures have been analyzed, monetary policy activities will be discussed in more detail. An increase in the money supply is referred to as expansive monetary policy, whereas a reduction in the money supply is referred to as contractionary monetary policy. An expansive monetary policy can be realized, for example, by an open market operation of the central bank, which increases the nominal money supply $M$. Assuming a fixed price level $P$, the increase in the nominal money supply automatically leads to a 1:1 increase in the real money supply $M∕P$.
In order to be able to examine the effects of the increase in money supply on production and interest rate, it must first be clarified whether, and if so, how the IS and LM curves shift. Since money supply $M$ does not directly influence the supply of goods or the demand for goods, and the variable $M$ does not enter into the IS equation, a change in money supply has no effect on the IS curve. On the other hand, the money supply enters the LM equation and, consequently, shifts the LM curve. With a fixed level of income and price, an increase in the money supply leads to a decrease in the interest rate. Consequently, the LM curve shifts downwards.

Now we will investigate how the shifts of the curves influence the equilibrium. An expansive monetary policy shifts the LM curve downwards, while the IS curve remains unchanged. Therefore, the economy moves along the IS curve and the equilibrium shifts from point $\mathit{Eq}0$ to $\mathit{Eq}$. Thus, production increases from $Y0$ to $Y$, and the interest rate decreases from $i0$ to $i$.
The increase in money supply thus leads to a lower interest rate, which stimulates investment. The multiplier process also increases demand and income. In contrast to the case of contractionary fiscal policy discussed above, it is now possible to make an exact statement about how the individual components of demand develop: As income rises and taxes remain unchanged, the disposable income rises and with it consumption. Investment increases because of increased sales as well as decreased interest rates. Hence, it can be deduced that an expansive monetary policy is more conducive to investment activity than an expansive fiscal policy.
In contrast to an expansive monetary policy, a contractionary monetary policy, causing a decline in the money supply, shifts the LM curve upwards. In this case, income falls and the interest rate rises.

The decline of the interest rate can be explained by the increased supply of liquidity and thus the decline of the price of liquidity (interest rate). Alternatively, the functional form of the LM curve can be considered. Converting the equation $M=Y\mathit{PL}\left(i\right)$ the following is obtained

$$i=L^{-1}\left(\frac{YP}{M}\right).$$

Since $L$ is monotonically increasing, so is $L^{-1}$. Thus, increasing $M$ reduces the argument and the value of the function. The graph shifts downwards.