In economy A, the LM curve is very steep, but not vertical (call this the “Friedman” economy) while in economy B, the LM curve is very flat (call this the “Keynesian” economy). The economies are identical in all other respects.
(a) What is the economic meaning of the different slopes of the LM curves?
(b) Compare the response in economy A to the response in economy B when there is an increase in G. Specifically, compare the change in Y, in the interest rate, and the potential for crowding out. (HINT: Use a single graph with two LM curves, one for economy A and one for economy B. Assume the IS curve is the same in both economies and show it on the graph.)
(c) Explain the reasoning behind each outcome by examining the adjustment in the money market. Focus on the demand for money.