Policy EffectivenessPolicy EffectivenessThe main objectives of a government policy is to cure certain macroeconomic problems, such as recession, unemployment, and inflation.This can be done by influencing real output.To cure recession and unemployment, real output should be raisedTo cure inflation, real output should be reduced
Policy Effectiveness (Cont.)Policy Effectiveness (Cont.)To determine whether a policy is effective or not, we look at the size of the change in real output associated with the policy changes.If the size of the change in real output is big, the policy is effective, and vice-versa.How much real output will change as a result of a policy change is determined by the slope of the ISand LMcurves.
MP effectiveness & the slope of the MP effectiveness & the slope of the ISIScurvecurve•IS0– Steep IScurve (low interest elasticity of investment)•IS1– Flat IScurve (high interest elasticity of investment)•An increase in MSshifts the LMcurve from LM0to LM1-Steep IS curve, rfalls a lot to r2, but Yincreases a little bit to Y2-Flat IScurve, rfalls a bit to r1, but Yincreases a lot to Y1•Conclusion: Monetary Policy is more effective when IS curve is flat (interest elastic)IS0IS1LM1r1LM0r0r2Y0YrY2Y1
FP effectiveness & the slope of the IS curveFP effectiveness & the slope of the IS curveSteep IS curve (low interest elasticity of investment)Flat IS curve (high interest elasticity of investment)An increase in government spending shifts the IS curve from IS0to IS1-