DSE 2009

[Manvendra]

Hi Folks..

An increase in the expected rate of inflation leads to a rightward shift of the LM Curve which decreases the interest rate and increases the equilibrium level of income.

Kindly explain the logic behind the above assertion.


Thanks

[samaira]

i dont think increase in expected inflation will cause rightward shift. i think it will cause left upwards shift increasing the interest rates and decreasing the income.

[duck]

Hi Manvendra.. :)

Expected inflation = Nominal int rate(i) - Real int rate(r)

Suppose, we are plotting in (Y,r) space.
Now, Increase in expected inflation will have no impact on IS equation because IS is a function of (r,Y)
But, it will result in a downward shift in LM curve because a real interest rate must reduce to get the old level of nominal interest rate (that is, i = r + expected inflation.. so, an increase in expected inflation would result in a decrease in "r" to keep the same level of "i" )

Hence, Equilibirum level of putput rises and "r" decreases.