b Interest inelastic Money Demand r 1 LM IS IS1 ED E r Y 2 Y Y 1 Y r G IS curve

B interest inelastic money demand r 1 lm is is1 ed e

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(b) Interest-inelastic Money Demand r 1 LM IS 0 IS 1 E’ D E r Y 2 Y 0 Y 1 Y r 0 G IS curve shift to the right (from IS 0 to IS 1 ) Y (from Y 0 to Y 2 ) Y MD  r (from r 0 to r 1 ) r I   Y (from Y 2 to Y 1 ) Final equilibrium: r 1 , Y 1 Conclusion: G   Y (but up to Y 1 only and not Y 2 ) Crowding-out effect Y (from Y 2 to Y 1 ) The size of the crowding-out effect = Y 1 Y 2 The size of the crowding-out effect is bigger when LM curve is inelastic (steeper). Crowding-out effect Since the MD is interest elastic, a large rise in interest rate is required to reequilibrate the money market after the increase in the money stock. As a consequence, I & Y decrease by a greater amount.
The Relative Effectiveness of Monetary & Fiscal Policy
How the slopes of LM & IS curves determine the effectiveness of MP & FP?
Monetary Policy Effectiveness & the Slope of the IS Curve (a) Interest-inelastic investment r 2 LM 0 IS 0 LM 1 E’ E r Y 1 Y 2 Y r 1 Suppose that MS (expansionary MP) while P unchanged. MS   LM curve shifts downward. r (from r1 to r3) I   Y (from Y 1 to Y 2 ). Y MD   r (from r 3 to r 2 ). Final equilibrium: r 2 , Y 2 Conclusion: MS r and Y . MS   Y (but only a smaller increase in Y) Monetary policy is less effective (has a small effect on Y) when the investment is interest-inelastic. r 3 Since the I is interest inelastic, a large drop in interest rate causes only a small increase in Y.
Monetary Policy Effectiveness & the Slope of the IS Curve (b) Interest-elastic investment r 2 LM 0 IS 0 LM 1 E’ E r Y 1 Y 2 Y r 1 Suppose that MS (expansionary MP) while P unchanged. MS   LM curve shifts downward. r (from r1 to r3) I   Y (from Y 1 to Y 2 ). Y MD   r (from r 3 to r 2 ). Final equilibrium: r 2 , Y 2 Conclusion: MS r and Y . MS   Y (a larger increase in Y) Monetary policy is effective (has a larger effect on Y) when investment is interest-elastic. r 3 Since the I is interest elastic, a small drop in interest rate causes a larger increase in Y.
Monetary Policy Effectiveness & the Slope of the IS Curve (c) Completely Interest-inelastic investment r 2 LM 0 IS 0 LM 1 E’ E r Y 1 Y r 1 Suppose that MS (expansionary MP) while P unchanged. MS   LM curve shifts downward. r (from r 1 to r 2 ) and Y unchanged. Final equilibrium: r 2 , Y 1 Conclusion: MS r and Y unchanged. MS Y unchanged Monetary policy is completely not effective (has no effect on Y) when investment is completely interest-inelastic. Since the I is completely interest inelastic, a large drop in interest rate has no effect on I and therefore, on Y.
Monetary Policy Effectiveness & the Slope of the IS Curve (d) Completely interest-elastic investment LM 0 IS 0 LM 1 E’ E r Y 1 Y r 1 Suppose that MS (expansionary MP) while P unchanged. MS   LM curve shifts downward. r is unchanged and Y (from Y 1 to Y 2 ) Final equilibrium: r 1 , Y 2 Conclusion: MS r is unchanged and Y . MS   Y

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