(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.