The IS-LM Model
This paper analyses the possible short-term and long-term effects of a reduction in the money supply using the investment savings – liquidity money (IS-LM) and aggregate supply-aggregate demand (AS-AD) models. As shall be seen, a decrease in money supply affects the amount of investments, interest rate, availability of goods and services, price levels and the overall GDP.
IS-LM Model
The IS-LM model explains how the consumption of goods and services as well as savings interacts with liquid funds. A reduction in the money supply leads to a decrease of money at points on the LM and IS curves shifting the curves to the left.
Short-Term Effects
The short-term effects will be taken to suggest the effects before the money supply can influence
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A reduction of the money supply leads to decreased inflation in the long-run. This is because less money in the market means less money available to purchase and less demand for goods and services, which in turn leads to reduced prices – decreasing the inflation rate. Over the long-term, higher interest rates will cause decreased investments that lead to a decreased output and begin to decrease interest rates again.
Another likelihood in the increase in the value of the currency. This may be the case because there will be a limited amount of money chasing a set amount of goods and services. The demand for the goods and services will decrease and prices will stop increasing as well. An appreciation of the currency may make the exports more expensive. But it is also worth noting that an increase in the value of a currency leads to a decrease in interest
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The reason for an increase in the interest rates is because of the decreased supply – which automatically increases the cost of borrowing. On the other hand, the decrease in the nominal output is caused by a decrease in demand for goods and services. The possible long-term effects of a decline in money supply using the IS-LM and AS-AD models is reduced inflation rate and valuation of the currency. When the circulation of money decreases, the demand for goods and services also decrease reducing their prices. This in turn leads to the increase in the value of the currency as there is less money chasing a fixed amount of goods and
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