To understand how changes in monetary policy affect the position of the LM curve you should recall how the LM curve is derived. The LM curve (panel at right) represents the combinations for income, Y, and the interest rate, i, consistent with equilibrium in the money market (panel at left). Move the handle in panel at right rightward and leftward, graphically representing changes in the level of income.

1. What happens to the equilibrium level of i as Y goes up and down ?

To draw the LM curve, we′ve held all monetary policy variables – which means we′re referring to the money supply – constant. Let's see how changing monetary policy affects the position of the LM curve.

2. Suppose the Chairman of the Federal Reserve decided to increase the money supply. How do you expect this increase to affect the equilibrium interest rate in the money market ?
3. Is the new combination of i and Y, resulting from the increase in money supply, a point somewhere on the LM₀ curve ?
4. Move the handle in panel at right rightward and leftward, graphically representing changes in the level of income. How does changing the level of income affect the equilibrium interest rate in the money market ?
5. What do the series of dots in panel at right look like ?
6. What does the LM₁ curve represent ?

Together with the IS curve, the LM curve will tell us what are the interest rate and income in an economy. As monetary and/or fiscal policy changes, we can trace out their effects by looking at how the IS and LM curves shift and the resulting effects on i and Y. Move on to the next active graph to see how this works.