A decrease in the price level shifts the curve to the right, and the aggregate demand curve
a. IS; shifts to the right
b. IS; does not shift
c. LM; shifts to the right
d. LM; does not shift
The Correct Answer and Explanation is:
Correct Answer: c. LM; shifts to the right
Explanation (300+ words):
To understand this question, it’s important to review how price level changes affect the IS-LM model, which is a fundamental model in macroeconomics used to determine equilibrium in the goods and money markets.
The IS Curve:
The IS curve represents equilibrium in the goods market, where investment (I) equals savings (S). The IS curve shows combinations of interest rates and output (GDP) where the goods market is in balance. It is not directly affected by changes in the price level, since it’s based on real spending and investment decisions.
The LM Curve:
The LM curve represents equilibrium in the money market, where money demand equals money supply. It is derived using the real money supply (nominal money supply divided by the price level). This curve shows combinations of interest rates and output at which the money market is in balance.
Impact of a Decrease in the Price Level:
When the price level falls, the real money supply increases because:
$$
\text{Real Money Supply} = \frac{\text{Nominal Money Supply}}{\text{Price Level}}
$$
As the denominator (price level) decreases, the real money supply increases. This effectively increases the amount of money available in real terms in the economy.
With more real money available, the interest rate falls (since there’s less pressure on borrowing), which stimulates investment and raises aggregate demand. This shifts the LM curve to the right, showing that at every level of output, the interest rate can be lower due to the increased real money balances.
Why Not the Other Options?
- a. IS; shifts to the right – Incorrect: The IS curve does not respond to price level changes directly.
- b. IS; does not shift – Partially correct, but irrelevant to the LM shift.
- d. LM; does not shift – Incorrect: The LM curve does shift with price level changes.
Conclusion:
A decrease in the price level increases the real money supply, lowers interest rates, and shifts the LM curve to the right. Thus, option c is the correct choice.