Refer to figure 5 below. In figure 5, national income has fallen from its full employment level Y_F to a lower level, Y_U, at which there is unemployment. This may have been due to a decline in exports that has shifted the IS curve to the left. What might cause the LM curve to automatically move to the right and so move the economy back towards Y_F? Figure 5

Question

Quizplus · Accepted Answer

A fall in the general level of prices (deflation) would lead to a fall in the demand for money. This would cause interest rates to fall, leading to an increase in investment and consumption expenditure, shifting the IS curve to the right. The LM curve would shift to the right as well, as the fall in the demand for money would lead to an increase in the money supply. This would lead to a higher equilibrium level of output and a move towards full employment. A rise in prices (inflation) would have the opposite effect, shifting the LM curve to the left and making it harder to reach full employment. Changes in government spending and taxes would impact the IS curve but not necessarily the LM curve.

Refer to Figure 5 Below