2
Conclusion:
MS
r is unchanged and Y
.
MS
Y
Monetary policy is
most effective
(has a largest effect
on Y) when investment is completely interest-elastic.
Y
2
Since the I is completely interest elastic, a
small drop in interest rate has a largest effect
on I and therefore, on Y.

Fiscal Policy Effectiveness & the
Slope of the IS Curve
(a) Interest-elastic investment
r
1
LM
IS
0
IS
1
E’
E
r
Y
0
Y
1
Y
r
0
Suppose that G
(expansionary FP)
G
IS curve shift to the right (from IS
0
to IS
1
)
Y
(from Y
0
to Y
1
)
r
(from r
0
to r
1
)
Final equilibrium: r
1
, Y
1
Conclusion:
G
Y
Fiscal policy is
less effective
(has a smaller effect on Y)
investment is interest-elastic.
Since the I is interest elastic, an increase in
interest rate causes a larger C-O effect. As a
result, FP is less effective (only a small
increase in Y).
Y
2
D

Fiscal Policy Effectiveness & the Slope of the IS Curve(b) Interest-inelastic investmentr1LMIS0IS1E’ErY1Y0Yr0GIS curve shift to the right (from IS0to IS1)Y(from Y0to Y1)r(from r0to r1) Final equilibrium: r1, Y1Conclusion: G Conclusion: G Fiscal policy is effective (has a larger effect on Y) when investment is interest-inelastic.Since the I is interest inelastic, an increase in interest rate causes a smaller C-O effect. As a result, FP is more effective (has a greater increase in Y).Y2D
Y
Y

Fiscal Policy Effectiveness & the Slope of the IS Curve(c) Completely Interest-inelastic investmentr1LMIS0IS1E’ErY1Y0Yr0GIS curve shift to the right (from IS0to IS1)Y(from Y0to Y1)r(from r0to r1) Final equilibrium: r1, Y1Conclusion: G Conclusion: G Fiscal policy is most effective (has a largest effect on Y) when investment is completely interest-inelastic.Since the I is completely interest inelastic, an increase in interest rate has no C-O effect. As a result, FP is most effective (has a largest increase in Y).
Y
Y

Fiscal Policy Effectiveness &
the Slope of the IS Curve
(d) Completely Interest-elastic investment
LM
IS
0
= IS
1
E
r
Y
0
= Y
1
Y
r
0
G
IS curve shift to the right (from IS
0
to IS
1
)
Final equilibrium: r
0
, Y
0
Conclusion:
G
Y unchanged
Conclusion:
G
Y unchanged
Fiscal policy is
most ineffective
(has no effect
on Y) when investment is completely interest-
elastic.
Since the I is completely interest elastic, an
increase in interest rate has a complete C-O
effect. As a result, FP is not effective (has no
effect on Y).

Monetary Policy Effectiveness &
the Slope of the LM Curve
(a) Interest-inelastic money demandr1LM1IS0LM0E’ErY0Y1Yr0Suppose that MS(expansionary MP) while P unchanged.MSLM curve shifts downward.r(from r0to r1) Y(from Y0to Y1).Final equilibrium: r1, Y1Conclusion: MS rand YMS Y (a larger increase in Y)Monetary policy is effective (has a large effect on Y) when money demand is interest-inelastic.Since the MD is interest inelastic, a large drop in interest rate is required to reequilibrate the money market after the increase in the money stock. As a consequence, I & Y increase by a greater amount.
.