8.Policy Effectiveness - Policy Effects in the IS-LM Model Policy Effectiveness The main objectives of a government policy is to cure certain

8.Policy Effectiveness - Policy Effects in the IS-LM...

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Policy Effects in the IS-LM Model
Policy Effectiveness The 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 raised To cure inflation, real output should be reduced
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 IS and LM curves.
MP effectiveness & the slope of the IS curve IS 0 Steep IS curve (low interest elasticity of investment) IS 1 Flat IS curve (high interest elasticity of investment) An increase in MS shifts the LM curve from LM 0 to LM 1 - Steep IS curve, r falls a lot to r 2 , but Y increases a little bit to Y 2 - Flat IS curve, r falls a bit to r 1 , but Y increases a lot to Y 1 Conclusion: Monetary Policy is more effective when IS curve is flat (interest elastic) IS 0 IS 1 LM 1 r 1 LM 0 r 0 r 2 Y 0 Y r Y 2 Y 1
FP effectiveness & the slope of the IS curve Steep 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 IS 0 to IS 1 - Steep IS curve: r and Y increase a lot to r 1 and Y 1,

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