Changes in monetary policy variables lead to shift in LM curve. The LM curve is affected by the changes in exogenous variables or by the behavioral shift in the demand for money. The two main factors that affect the LM curve include change in demand for money and change in supply of money. The effect of these factors have been explained below:
Changes in Money Supply
The increase in money supply due to the government’s monetary expansion policy, shifts the LM curve rightwards. When the central monetary authority of the government or the country adopts an easy expansionary monetary policy, the supply of money increases in the economy and the LM curve shifts right. Expansionary or easy monetary policies include lower bank discount rates, purchase of securities in open market, and reduction in required reserve ratio (RRR).
On the other hand, a decline in money supply will lead to the leftward shift of the LM curve. When the government follows a contractionary monetary policy, supply of money in the economy declines. Under a tight monetary policy, the central bank raises the bank rates, makes sale of securities in the open market, and increases the RRR requirements as well.
As a result of this, shortage of money occurs at points on the initial LM curve. The condition for excess demand of money in the market can only be eliminated by increasing the interest rate, which reduces the quantity of money demanded, until it reaches a point where supply of money is equal to demand of money.
Autonomous Changes in Money Demand
The theory of asset motive states that there can be an autonomous rise in the demand for money. This means that no change occurs in the money demand even due inflation, deflation, interest rates, or the level of aggregate output/income.
For instance, when the return on bonds become unstable, dealing with bonds become more riskier than money, and the demand for money would increase at any given level of output, interest rate, or price levels. When holding bonds become a riskier asset, people would want to shift from holding bonds to holding money.
The increase in autonomous demand for money thus shifts the LM curve to the left, although the rising demand for money results in the rate of interest at any given level of output.