3.2 The shift of the LM curve in a closed economy

When deriving the LM curve, we assumed that both the money supply $M$ and the price level $P$ – and thus also the relationship between both variables, the real money supply $M∕P$ – are fixed.

However, changes in the real money supply, for example by inflation or monetary policy measures, shift the LM curve.

An increase in the nominal money supply $M$ thus has the same effect as a decrease in the price level $P$, the real money supply $M∕P$ increases.

If, for example, the nominal money supply is increased and the price level $P$ remains constant, then the real money supply increases. For each income level, the interest rate $i$, which enables an equilibrium on the money and financial market, is now lower and as a result the LM curve shifts downwards.

Similarly, a reduction in the money supply, whether caused by a decrease in the nominal money supply $M$ or by an increase in the price level $P$ (inflation), leads to an increase in the interest rate $i$. for every income level. Here, the LM curve shifts upwards.

In addition, the initial interest rate is movable between 2 and 10, so that the effects of a changing interest rate can also be observed. It can be seen that at high interest rates the sensitivity of income in regard to a money supply expansion is less than at low interest rates.