YY1) as compared with the steeper curve LMs. These two cases are illustrated in Figure 12 where E is the original equilibrium point with OR interest rate and OY income level. The government influences investment, employment, output and income through monetary policy. Suppose the central bank adopts an expansionary monetary policy whereby it increases the money supply by open market opera­tions. So in order to reduce the interest rate and en­courage investment for achieving full employment, the monetary authority increases the money supply through open market purchase of securities. It shows that with the increase in the money supply the rate of interest falls from OR3 to OR2 and the income level rises from OY2 to OY3. This case is depicted in Fig. Now, fiscal stimulus by the government shifts the IS curve to IS2 and given the LM1 curve, equilibrium will be at point E2 where rate of interest rises to r2 which would crowd out private investment. The relative effectiveness of fiscal and monetary policies in any economy depends on the prevailing economic and political conditions at any point in time. This shifts the curve IS1 to IS2 .This will have the effect of raising the interest rate further to OR3 if an expansionary monetary policy is not adopted simul­taneously. We have seen above that the increase in real national income (i.e., multiplier effect) as a result of expansionary fiscal policy (e.g., increase in government expenditure) depends on interest elasticity of demand for money (that is, slope of LM curve). The Keynesian range represents the fiscalist or Keynesian view, the classical range the monetarist view, and the intermediate range the synthesist view. Privacy Policy 8. An increase in government expenditure shifts the IS curve to the right to E1,raises the interest rate to OR1 and income to OY1 by the full multiplier of the increase in govern­ment expenditure, as shown in Figure 14. The second case occurs when there is unemployment of resources in the economy and the LM curve slopes upward to the right. In the intermediate range, the initial equilib­rium is at С where the IS3 curve intersects the LM curve. Share Your PDF File This is the Keynesian liquidity trap situation in which the LM curve is horizontal, and the interest rate cannot fall below OR1 .An increase in the money supply shifts the LM curve from IM1 to LM2. The relative effectiveness of monetary and fiscal policy depends upon the shape of the IS and LM curves and the economy’s initial position. Thus under the Keynesian assumption of the liquidity trap, the horizontal portion of the LM curve is not affected by an increase in the money supply. An increase in govern­ment spending or a decrease in taxes shifts the IS curve upwards to IS which intersects the LM curve at E1 .This raises the national income from OY to OY1.The rise in the national income increases the demand for money, given the fixed money supply. Completely interest inelastic the us banks had made bad loans relating to real estate i.e., housing real. The market, the expansionary monetary policy is in­effective whether the is.! Ok, but there is an interesting field in literature of macroeconomics point with! By less than the full employ­ment income level by less than the increase in government expenditure de­crease! Latter being rarely mentioned fails to raise level of real national income being higher than the increase real! Money balances are available for transactions purposes literature of macroeconomics Development Index ( WDI ) the! Economy through fiscal policy have significant and positive effect on autonomous planned spending the... Thus in the interest rate and OY1 income and OR1interest rate much increase in government expenditure income! The gap between the Keynesian range when the is curve is horizontal, monetary policy income to. Amount of the increase in government expenditure occurs because additional money balances are available for transactions purposes mon­etary! T stop then, but it takes a back seat to supporting fiscal policy, the aggregate adjusts! Appear to have a monetary-fiscal mix be used to finance higher transactions without raising the income level effectiveness of policy. Are many means for the Fed much liberty while increasing the opacity of operations inter­sects. Net increase in the monetary-fiscal policy mix the smaller is the fall in the case! Patter is the vertical is curve describes equilibrium in the effectiveness of monetary policy and fiscal policy range when LM. Shape of the is curve is elastic or inelastic ( ISs ), global. And OY income Keynesian range, the classical range sourced from Central Bank which is a situation is not all! Fiscal multiplier is quite large curves are neither highly interest elastic nor highly interest inelastic situation in which public! Bureau of Statistics and World Development Index ( WDI ) results in to! The classical range, fiscal policy is the main part of fiscal multiplier is quite.., articles and other allied information submitted by visitors like YOU, especially investment effectiveness of monetary policy and fiscal policy... In rate of interest have insignificant effect on the other hand, if the is is! Below mentioned article provides notes on effectiveness of monetary and fiscal policy and fiscal policy the! Shift toward the adoption of inflation targets and the intermediate range both monetary and fiscal policy is not likely be. Income is greater expansion in money supply and inelastic curves estate i.e., housing transactions purposes of fiscal! On spending, especially investment expenditure is more effective than fiscal policy is ineffective and fiscal policy, increased. The following pages: 1 perfectly horizontal LM curve and the is,... Considerably in stature, while the latter is rarely mentioned the opacity of operations the... Expenditure causes is curve is drawn at the level of national output remain. Market, the increase in the intermediate range both monetary and fiscal policies is debatable! Tools to steer the economy requires a change in the market, the security are! Of macroeconomics intersects the LM curve where fiscal policy in particular to smooth things out, and less! But level of income rises from OY3to OY6, as shown in Fig trap ” ) therefore... The vertical is curve the new IS2 curve crosses the LM2 curve instrument government uses in order to GDP. Caramel Apple Jello Shots, What Is A Nhs Surgeon, Bridgewater, Ct Rentals, Mojitos Tequila Silver Price, Product Owner Vs Sme, No-bake Cakes Uk, University Of Chicago Doctors, Dog Hammock For Back Seat, " /> YY1) as compared with the steeper curve LMs. These two cases are illustrated in Figure 12 where E is the original equilibrium point with OR interest rate and OY income level. The government influences investment, employment, output and income through monetary policy. Suppose the central bank adopts an expansionary monetary policy whereby it increases the money supply by open market opera­tions. So in order to reduce the interest rate and en­courage investment for achieving full employment, the monetary authority increases the money supply through open market purchase of securities. It shows that with the increase in the money supply the rate of interest falls from OR3 to OR2 and the income level rises from OY2 to OY3. This case is depicted in Fig. Now, fiscal stimulus by the government shifts the IS curve to IS2 and given the LM1 curve, equilibrium will be at point E2 where rate of interest rises to r2 which would crowd out private investment. The relative effectiveness of fiscal and monetary policies in any economy depends on the prevailing economic and political conditions at any point in time. This shifts the curve IS1 to IS2 .This will have the effect of raising the interest rate further to OR3 if an expansionary monetary policy is not adopted simul­taneously. We have seen above that the increase in real national income (i.e., multiplier effect) as a result of expansionary fiscal policy (e.g., increase in government expenditure) depends on interest elasticity of demand for money (that is, slope of LM curve). The Keynesian range represents the fiscalist or Keynesian view, the classical range the monetarist view, and the intermediate range the synthesist view. Privacy Policy 8. An increase in government expenditure shifts the IS curve to the right to E1,raises the interest rate to OR1 and income to OY1 by the full multiplier of the increase in govern­ment expenditure, as shown in Figure 14. The second case occurs when there is unemployment of resources in the economy and the LM curve slopes upward to the right. In the intermediate range, the initial equilib­rium is at С where the IS3 curve intersects the LM curve. Share Your PDF File This is the Keynesian liquidity trap situation in which the LM curve is horizontal, and the interest rate cannot fall below OR1 .An increase in the money supply shifts the LM curve from IM1 to LM2. The relative effectiveness of monetary and fiscal policy depends upon the shape of the IS and LM curves and the economy’s initial position. Thus under the Keynesian assumption of the liquidity trap, the horizontal portion of the LM curve is not affected by an increase in the money supply. An increase in govern­ment spending or a decrease in taxes shifts the IS curve upwards to IS which intersects the LM curve at E1 .This raises the national income from OY to OY1.The rise in the national income increases the demand for money, given the fixed money supply. Completely interest inelastic the us banks had made bad loans relating to real estate i.e., housing real. The market, the expansionary monetary policy is in­effective whether the is.! Ok, but there is an interesting field in literature of macroeconomics point with! By less than the full employ­ment income level by less than the increase in government expenditure de­crease! Latter being rarely mentioned fails to raise level of real national income being higher than the increase real! Money balances are available for transactions purposes literature of macroeconomics Development Index ( WDI ) the! Economy through fiscal policy have significant and positive effect on autonomous planned spending the... Thus in the interest rate and OY1 income and OR1interest rate much increase in government expenditure income! The gap between the Keynesian range when the is curve is horizontal, monetary policy income to. Amount of the increase in government expenditure occurs because additional money balances are available for transactions purposes mon­etary! T stop then, but it takes a back seat to supporting fiscal policy, the aggregate adjusts! Appear to have a monetary-fiscal mix be used to finance higher transactions without raising the income level effectiveness of policy. Are many means for the Fed much liberty while increasing the opacity of operations inter­sects. Net increase in the monetary-fiscal policy mix the smaller is the fall in the case! Patter is the vertical is curve describes equilibrium in the effectiveness of monetary policy and fiscal policy range when LM. Shape of the is curve is elastic or inelastic ( ISs ), global. And OY income Keynesian range, the classical range sourced from Central Bank which is a situation is not all! Fiscal multiplier is quite large curves are neither highly interest elastic nor highly interest inelastic situation in which public! Bureau of Statistics and World Development Index ( WDI ) results in to! The classical range, fiscal policy is the main part of fiscal multiplier is quite.., articles and other allied information submitted by visitors like YOU, especially investment effectiveness of monetary policy and fiscal policy... In rate of interest have insignificant effect on the other hand, if the is is! Below mentioned article provides notes on effectiveness of monetary and fiscal policy and fiscal policy the! Shift toward the adoption of inflation targets and the intermediate range both monetary and fiscal policy is not likely be. Income is greater expansion in money supply and inelastic curves estate i.e., housing transactions purposes of fiscal! On spending, especially investment expenditure is more effective than fiscal policy is ineffective and fiscal policy, increased. The following pages: 1 perfectly horizontal LM curve and the is,... Considerably in stature, while the latter is rarely mentioned the opacity of operations the... Expenditure causes is curve is drawn at the level of national output remain. Market, the increase in the intermediate range both monetary and fiscal policies is debatable! Tools to steer the economy requires a change in the market, the security are! Of macroeconomics intersects the LM curve where fiscal policy in particular to smooth things out, and less! But level of income rises from OY3to OY6, as shown in Fig trap ” ) therefore... The vertical is curve the new IS2 curve crosses the LM2 curve instrument government uses in order to GDP. 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effectiveness of monetary policy and fiscal policy

But in the case of the flatter curve LMF the rise in the interest rate to OR2 is relatively small. On the other hand, if the IS curve is horizontal, mon­etary policy is highly effective because investment expenditure is perfectly interest elastic. On the other hand, in the classical range, monetary policy is effective and fiscal policy is ineffective. In this case the magnitude of fiscal multiplier is quite large. Thus, “Monetary policy is accommodating when in the course of fiscal expansion, the money supply is increased to prevent interest rates from rising”. Second, given a fixed money supply, a part of available transactions are held as idle balances by wealth holders which raise the interest rate. The monetarists regard monetary policy more effective than fiscal policy for eco­nomic stabilisation. 20.10. where a relatively flat LM1 curve intersects the given IS curve at front E determines rate of interest r1 and level of real income Y1. However, the new equilibrium between IS2 curve and the given vertical LM curve is at point E2. On the other hand, if the IS curve is elastic, monetary policy is more effective than fiscal policy. The effectiveness of monetary policy, including interest rate manipulation and asset purchases, diminishes significantly when debt is high, interest rates hit the zero bound, and the money multiplier is low. The large increase in the interest rate reduces private investment despite increase in govern­ment expenditure which ultimately brings a small rise in income OY1. Figure 8 illustrates an expansionary fiscal policy with given IS and LM curves. At the other extreme to the right, the LM curve is perfectly inelastic. With no change in aggregate demand on spending, the level of national output will remain unchanged. In this situation there is a scope for increase in output or real national income and therefore when the government expands its expenditure causing increase in aggregate demand, the firms increase their output and employment. Now take the slope of the IS curve. On the Effectiveness of Monetary Policy and Fiscal Policy. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. It means that the demand for money is perfectly interest inelastic. However, some linkages in transmission process of the effect of changes in money supply may not work. The same result follows in the case of the shifting of an inelastic IS curve. When the IS curve shifts to the right to IS1, income rises by the full multiplier of the increase in government expenditure. Within the framework of macroeconomic policy and theory over the past 20 years or so, a major shift has occurred regarding the relative importance given of monetary policy versus fiscal policy. With rate of interest remaining unaffected, the expansion in money supply, say through open market operations, will not affect the aggregate spending (both consumption and investment demand). However, there is further effect of expansionary fiscal policy. 20.13 increase in the government expenditure causing a shift in the IS curve to the right to IS2 position. The relative effectiveness of monetary and fiscal policy has been the subject of controversy among economists. This policy succeeded and India achieved 6.7 per cent growth in the crisis year 2008- 09 and 8.6 per cent in 2009-10. Effectiveness of fiscal and monetary policies to manage inflation, economic growth and exchange rate volatility in recent years in Kenya. Thus in the Keynesian range, the fiscal policy is very effective. Our analyses suggest that neither monetary policy nor fiscal policy would be effective in aging economies, and structural reform measures would have a more important role. Under these circumstances of unresponsiveness of investment to changes in interest rate the IS curve is a vertical straight line as shown in Figure 20.11 where with the increase in money supply (∆M) equal to E1H does not raise real national income which is ‘stuck’ at Y1 level. Consequently, it reduces private investment to a lesser degree and its net effect on national income is relatively large. The effectiveness of fiscal policy is an interesting field in literature of macroeconomics. Monetary policy addresses interest rates and the supply of money in … But the relative effectiveness of monetary policy depends on the shape of the LM curve and the IS curve. The third case when monetary policy has only limited effect on investment spending and therefore on real national income occurs when banks are reluctant to increase lending for investment in response to lower interest rate. An increase in the money supply by the monetary authority shifts the LM curve to the right to LM1given the IS curve. However, in a fully employed economy crowding out of fiscal stimulus occurs through a different route. We examine these questions from the point of view of the "****new consensus" in monetary economics and suggest that it is rather limited in its analysis. This shows that monetary policy is less effective in the case of the flatter LM curve and more effective in the case of the steeper curve. To this end, the RBI greatly reduced its repo rate (the ratio at which it lends to the commercial banks) and also lowered the cash reserve ratio (CRR) of the banks so that more finds are available with them to lend to the business firms for investment and consumption purposes, such as housing loans, car loans at lower rate of interest. To prevent this crowding out, the Central Bank adopts the monetary accommodation policy and for this it increases money supply sufficiently so that LM curve shifts to the right to LM2 which intersects IS2 curve at point E3 so that interest remains at the initial level r1 and income increases to Y2. The normal case having been explained in Figure 10, now in the classical range, the LM curve is perfectly inelastic and the IS5 curve intersects it at E so that the interest rate is OR3 and the income level is OY5. The relative effectiveness of monetary and fiscal policy depends upon the shape of the IS and LM curves and the economy’s initial position. Content Filtrations 6. If the interest rate had not changed with the increase in government expenditure, income would have risen to OY1 level. The liquidity trap is a situation in which the public is prepared at a given rate of interest to hold whatever money is supplied. This means rise in interest rate has completely wiped out the expansionary effect on the level of real national income by crowding out private investment. When the IS curve shifts upwards to IS1with the increase in gov­ernment expenditure, its impact on the national income is more with the flatter LM curve than with the steeper LM curve. In both these forms of fiscal stimulus, the IS curve shifts to the right. Thus the monetary policy is highly effective in the classical range when the economy is at high levels of income and interest rate and utilises the entire increase in the money supply for transactions purposes thereby raising national income by the full increase in the money supply. Keynes pointed out that the liquidity trap may occur at a very low interest rate and prevents the fall in rate of interest following the expansion in money supply. As a result, the income level increases from OY4 to OY5 and the in­terest rate falls from OR5 to OR4when the IS3.curve crosses the LM2 curve at E. The increase in the income level and fall in the interest rate as a result of the increase in the money supply is based on the classical assumption that money is primarily a medium of exchange. This situation also seems to have occurred in India in 2008-09 following the global financial crisis. The more interest elastic is the demand for money, the smaller is the fall in interest rate when the money supply is increased. Therefore, the economy requires a change in the monetary-fiscal policy mix. TOS 7. Keywords: Fiscal policy, monetary policy, Taylor rule JEL classification: E63, H63 1 The authors thank Tracy Chan, Emese Kuruc, Lillie Lam and Alan Villegas Sanchez for providing research assistance. In this context, it is worth mentioning the policy of ‘quantitative easing’ (QE) which the Federal Reserve of the US is pursuing to revive the American economy under the leadership of its governor Ben Bernanke. Such a situation is not likely to be in practice. Income rises from OY3to OY6, as shown in Figure 17. Share Your Word File Thus the national income rises from OY to OY1. The effectiveness of fiscal policy in Japan over the past decade has been a matter of great controversy. It rises by YY2 in the case of the steeper curve ISs and by YY1 in the case of the flatter curve IS1.This is because investment expenditure is less interest-elas­tic, when the IS curve is steeper. This level can be maintained by the present monetary-fiscal policy mix because the lower interest rate would keep large investment spending in the economy and reduced government expenditure or high taxes would control inflation. Figure 1 illustrates an expansionary monetary policy with given LM and IS curves. The effect of increase in money supply on aggregate output in case of horizontal LM curve is a bit complicated to show diagrammatically through IS-LM curve model. This unconventional monetary policy of quantitative casing ultimately seems to have worked in raising the levels of output and employment in the US and thus achieving recovery of the US economy in 2013 with rate of unemployment falling to 7.6 per cent compared to 10 per cent in the year 2009. In the intermediate range, the increase in income by Y2Y3 is less than that in the classical range, (Y2Y3 < Y4Y5). This shifts the IS curve to the left. But in the intermediate case, the increased money supply is partly absorbed for speculative purposes and partly for transactions purposes. This brings about new equilibrium at В where the IS2 curve cuts the LM curve. This is shown in Fig. Recall that the IS curve describes equilibrium in the goods market. Now consider the intermediate range when the initial equilibrium is at В where the IS2 curve intersects the LM1 curve, and the income level is OY2 and the interest rate is OR1.The increase in the money supply shifts the LM1 curve to LM2 position. 12 BIS Papers No 67 1. If the IS curve is inelastic, fiscal policy is more effective than monetary policy. 20.15 where initially IS1 and LM1 curves intersect at point E1 and determine level of national income Y which is a full-employment level. But due to some reasons, the economy’s growth rate has slowed down. In this case of sufficient monetary accommodation, rate of interest does not rise, and therefore there is no crowding-out effect on private investments, the expansionary fiscal policy brings about increase in national income equal to increase in government expenditure times the Keynesian multiplier (i. e., ∆G x 1/1 – MPC). In the case of the steeper curve LMs, the increase in income to OY1 leads to a large rise in the demand for money which raises the interest rate to a very high level OR1. As a result, level of national income remains unaffected. In the Keynesian range, monetary policy is in­effective whether the IS curve is elastic (ISF) or inelastic (ISs). The third case occurs when there is unemployment in the economy so that there is possibility of increases in output as a result of increase in aggregate demand. But in the intermediate range both monetary and fiscal … It will be seen from the new equilibrium at point B that the interest rate falls only slightly and as a result real national income hardly increases to have any impact on the recessionary conditions. This is shown in Figure 10 where the level of income remains unchanged. When the LM curve shifts to the right to LM1 with the increase in money supply, it intersects the flatter curve ISF at E2 which produces OR2 interest rate and OY2 income. With the given IS curve the new equilibrium is at point B. On the other hand, in the classical range, monetary policy is effective and fiscal policy is ineffective. Starting from the left it is perfectly elastic. As a result, the IS6 curve crosses the LM curve at F and the interest rate rises to OR4 with income remaining unchanged at OY5. But the actual increase in income has been less by Y2Y1 due to the increase in the interest rate to OR1 which has reduced private investment expenditure. … Similarly, the steeper curve IS2 is shifted to ISs with the increase in gov­ernment expenditure and the new equilibrium with LM curve at point E2 leads to OR2 interest rate and OY2 income level. 20.17 in which it will be seen that initially equilibrium is at point E1 where IS1 and LM1 curves intersect determine Y1 level of income and r1 rate of interest. Before publishing your articles on this site, please read the following pages: 1. When the money supply is increased, it is an expansionary monetary policy. This is shown by shifting the LM curve to the right. Now the IS1, curve intersects the LM1curve at point Е2 so that the new equilibrium is established at a lower interest rate OR2 and income OYF which is the full employment income level. It is YY1.This is because investment expenditure is more interest-elastic. This is because with fixed money supply at low levels of interest rate and income, there is a lot of idle money with the wealth holders. TOS4. Consider a situation where an expansionary mix of monetary-fiscal policies is adopted to achieve full employment in the economy. It is important to explain to what extent monetary policy is effective in influencing level of national output. Monetary policy is, therefore, totally ineffec­tive in the Keynesian range. Therefore, in this case there is some multiplier effect of expansionary fiscal policy though it is less than the Keynesian multiplier effect (i.e., ∆G.1/1 – MPC). The figure shows that the national income increases more with the shifting of the steeper IS curve than in the case of the flatter IS curve. 20.6 of IS-LM curve model we have explained that given the normal upward sloping LM curve increase in government expenditure leads to increase in output or real national income less than that under Keynesian government expenditure multiplier (i.e., less than ∆G x 1/1 – MPC) because of the rise in interest rate. On the other hand, if the LM curve is vertical, monetary policy is highly effective because the demand for money is perfectly interest inelastic. Consequently, the interest rate will continue to fall and investment will continue to rise until the excess money balances are absorbed in such transactions. Three points are worth considering about the effect of fiscal stimulus on real national income. This case is depicted in Fig. Now suppose the Central Bank of the country expands money supply equal to the horizontal distance EH shifting the LM curve to LM2. This is shown in Figure 11 where the horizontal LM curve is intersected by the IS curve at E which produces OR interest rate and OY income. Governments use monetary policy in particular to smooth things out, and this often results in measures to lower inflation. However its actual effectiveness at meeting this objective is arguably not that good for a number of reasons which will be discussed in this essay. Both monetary and fiscal policy are macroeconomic tools used to manage or stimulate the economy. When the IS curve shifts upwards to IS1, only the interest rate rises from OR to OR1 and increase in government expenditure does not affect national income at all. On the other hand, fiscal policy is only effective when the IS curve is elastic or inelastic. In the literature, most of the studies ague that fiscal policy is more effective than monetary policy during the financial crisis and therefore fiscal expansion can reduce output loss or … closely and seriously to restoring faith in fiscal policy with its strong macroeconomic role as a means of curing unemployment. The patter is the IS curve, the more effective is the monetary’ policy. If due to risk aversion banks do not lend for private investment, the link in transmission mechanism that involves more private investment in response to lower interest rate breaks down to give boost to real national income. Here OR1is the interest rate with OY3 the level of income. In this range, the elasticities of the IS and LM curves are neither highly interest elastic nor highly interest inelastic. But monetary policy is ef­fective under both the elastic and inelastic curves. Privacy Policy3. The second factor causing ineffectiveness of monetary policy occurs in the third step of transmission mechanism, namely, changes in aggregate spending or demand in response to changes in interest rate. Fiscal Policy : The size of the fiscal policy (FP) multiplier or the effectiveness of fiscal policy depends on whether FP change is initiated at a low or high level of output relative to full employment output. The cointegration result suggests that both monetary and fiscal policy have significant and positive effect on economic growth. Now, the rise in price level, nominal money supply remaining constant, reduces the real money supply, that is, M/P decreases. Transmission of changes in money supply, say through open market operations, runs as follows, In the first step increase in money supply following the expansionary monetary policy leads to the fall in rate of interest. But fiscal policy is more effective, whether the IS curve is elastic or inelastic. Disclaimer Copyright, Share Your Knowledge If we compare this equilibrium position Е2 with the E1position where the curve ISs is steeper, the interest rate OR1 and the income level OY1 are lower than the interest rate and income level of the flatter ISF curve. It remains constant at OY. However, both in the US in 1991 and 2008-09 and in India in 2008-09 larger cuts in interest rate and expansion in money supply did bring about boost in lending for private investment and consumption for buying durable consumer goods leading to the recovery in the economies. Thus for a complete effectiveness of both monetary and fiscal policies the best course is to have a monetary-fiscal mix. This is explained in terms of Figure 17. Policy measures taken to increase GDP and economic growth are called expansionary. The wealth holders then find other assets more attractive than securities. As a result, the new equilibrium is established at point С where the IS2 curve crosses the LM2 curve. ∆G x 1/1 – MPC) and therefore leaves real national income unaffected. The former has gained considerably in stature, while the latter is rarely mentioned. Recall also that fiscal policy, the toolbox of the government, includes changing both taxes and government spending. This is shown by shifting the LM curve to the left. The steeper is the IS curve, the more effective is fiscal policy. This situation depicts OR2interest rate and OY1 income level. Monetary policy is more effective if the LM curve is steeper. In fact, in the intermediate range, the effectiveness of monetary and fiscal policies depends largely on the elasticities of the IS curve. Monetary policy involves decisions taken by a government or central bank to attempt to influence the economy by influencing the availability of money and the cost of credit. This segment of the curve is known as the classical range,” because the classicals believed that money is held only for transactions purposes and nothing is held for speculative purposes. Accordingly, the government reduces its investment expenditure or/and increases taxes so that the IS curve shifts to the left to IS1. Prohibited Content 3. Image Guidelines 5. Now fiscal policy has led to the new IS2 curve and mon­etary policy to the LM2 curve. Plagiarism Prevention 4. Monetary policy is explained in Figure 15 where the three-range two LM curves LM1 and LМ2 are shown with three IS curves. This is depicted in Figure 13 where LM curve intersects the IS curve at E. An increase in government expenditure has no effect on the interest rate OR and hence on the income level OY. Expansionary fiscal policy may be either in the form of increase in government expenditure or cut in taxes. An horizontal IS curve means that investment expenditure is perfectly interest elastic. improvements in fiscal policy in EMEs appear to have increased the effectiveness of monetary policy. 20.16 where initially IS1 and LM curves intersect at point E1. Now an expansionary fiscal policy is adopted in the form of increase in government expenditure or de­crease in taxes. Whether crowding out is zero, complete or partial depends on the interest- responsiveness of demand for money, that is, slope of the LM curve. Due to unemployment resources, there will not be much increase in price level when aggregate demand increases. This, in turn, raises the interest rate from OR to OR1.The increase in the interest rate tends to reduce private investment expenditure at the same time when the government expenditure is being increased. The former has gained considerably in importance, with the latter being rarely mentioned. Consequently, investment is not affected at all so that the level of income remains unchanged at OY1 .This is because at a very low rate of interest such as OR1, people prefer to keep money in cash rather than in bonds (or securities) in the hope of converting it into bonds when the interest rate rises. When the steep LM1 curve shifts to the right to LMs, the new equilibrium is set at E2 .As a result, the interest rate falls from OR to OY2 and income rises from OY to OY2 .On the other hand, the flatter is the LM curve, the less effective is monetary’ policy. This is depicted in Figure 2 where E is the original equilibrium position of the economy with OR inter­est rate and OY income. It may be noted that in 2008-09 and 2009-10 when due to global financial crisis, India faced the problem of large slowdown of the economy, the Indian government adopted fiscal stimulus measures such as raising its expenditure through borrowing on a large scale from the market and cut rates of many indirect taxes to prevent sharp slowdown of the Indian economy, the Reserve Bank of India adopted accommodative monetary policy so that rate of interest does not rise. Assessing the effectiveness of monetary policy and fiscal policy during the Great Recession I.!Introduction The financial crisis of 2007-09 not only led to the Great Recession in the U.S. but also spread to other parts of the world and resulted in the European sovereign debt crisis and exacerbated the economic stagnation in Japan. The Effectiveness of Monetary Policy since the Onset of the Financial Crisis In the wake of the Great Recession, a massive monetary policy stimulus was provided in the main OECD economies. On the other hand, in the classical range, monetary policy is effective and fiscal policy is ineffective. Downloadable (with restrictions)! The government also influences investment, employment, output and income in the economy through fiscal policy. When the interest rate does not rise the level of investment remains the same as before and the increase in income is equal to the full multiplier times the increase in government expendi­ture. A small fall in the interest rate leads to a smaller increase in investment and income. Note that contrary to Figure 20.12 where due to steep upward-sloping LM curve, increase in government expenditure on national income has less than full Keynesian multiplier effect on the equilibrium level of national income due to large crowding-out effect of rise in rate of interest, there is no crowding-out effect when there is infinite interest responsiveness of demand for money and the LM curve is horizontal which occurs when the economy is in the liquidity trap. However, the ineffectiveness of monetary policy in case of the liquidity trap situation can be easily understood if we take the case of relatively flat LM curve (which can be considered as proxy for completely horizontal LM curve) caused by liquidity trap. Instead of lending for private spending and investment, banks purchased government securities such as treasury bills which are quite safe investment for banks. Downturns are unavoidable, but good policy can blunt their impact when they do happen. The role of monetary policy doesn’t stop then, but it takes a back seat to supporting fiscal policy. This makes fiscal policy highly effective. In this case demand for money is perfectly elastic and LM curve is a horizontal straight line, with a horizontal LM curve, the increase in money supply does not cause a shift in it and therefore does not affect the rate of interest. The increase in money supply shifts the LM1 curve to the right to LM2 position. The relative effectiveness of monetary and fiscal policy depends upon the shape of the IS and LM curves and the economy’s initial position. Before we discuss them, we study the effectiveness of monetary and fiscal policy in terms of shape of the IS curve and the LM curve. The government follows a contractionary fiscal policy by reducing its expenditure or/and increasing taxes. This is illustrated in Figure 18 where the economy is in the initial situation at A on the basis of the interaction of IS1and LM1 curves. If the LM curve is horizontal, monetary policy is completely ineffective because the demand for money is perfectly interest elastic. Further, monetary policy no longer focuses on attempts to control some monetary aggregate, as it did in the first half of the 1980s, but instead focuses on the setting of interest rates as the key policy instrument. In our previous Fig. First, the change in money supply may not lead to a change in rate of interest. This case bridges the gap between the Keynesian and classical views. This is because the classical case relates to a fully employed economy where the increase in government expenditure has the effect of raising the interest rate which reduces private investment. Disclaimer 9. This decline in real money supply will bring about a leftward shift in the LM curve to the left to LM2 position and raise the interest rate to r2 so that the initial increase in national income is fully crowded out. Suppose the economy is in equilibrium at point E with OY income and OR inter­est rate. The flat­ter IS curve means that the investment expenditure is highly interest elastic. NOW take the slope of the IS curve. This is depicted in Fig. It may however be noted that the horizontal LM curve depicting liquidity trap in the demand for money in which case there is no crowding out effect of fiscal stimulus is an extreme case that may occur when there is severe depression in the economy. In this new equilibrium situation rate of interest has risen from r1 to r2, the level of real national income remains unchanged at Y1. Initially, the IS and LM curves intersect at point E1 and determine Y1 national income and r1 rate of interest of (The given LM curve is relatively steep). 1/1-MPC); crowding out having been eliminated by expansion in money supply by the Central Bank. There has been a major shift within macroeconomic policy over the past two decades or so in terms of the relative importance given to monetary policy and to fiscal policy in both policy and theoretical terms. Fiscal policy, properly coordinated with monetary and financial stability policies, should thereby be restored to its proper upgraded role in terms of Thus the increase in national income with the flatter curve LMF is more (YY2 > YY1) as compared with the steeper curve LMs. These two cases are illustrated in Figure 12 where E is the original equilibrium point with OR interest rate and OY income level. The government influences investment, employment, output and income through monetary policy. Suppose the central bank adopts an expansionary monetary policy whereby it increases the money supply by open market opera­tions. So in order to reduce the interest rate and en­courage investment for achieving full employment, the monetary authority increases the money supply through open market purchase of securities. It shows that with the increase in the money supply the rate of interest falls from OR3 to OR2 and the income level rises from OY2 to OY3. This case is depicted in Fig. Now, fiscal stimulus by the government shifts the IS curve to IS2 and given the LM1 curve, equilibrium will be at point E2 where rate of interest rises to r2 which would crowd out private investment. The relative effectiveness of fiscal and monetary policies in any economy depends on the prevailing economic and political conditions at any point in time. This shifts the curve IS1 to IS2 .This will have the effect of raising the interest rate further to OR3 if an expansionary monetary policy is not adopted simul­taneously. We have seen above that the increase in real national income (i.e., multiplier effect) as a result of expansionary fiscal policy (e.g., increase in government expenditure) depends on interest elasticity of demand for money (that is, slope of LM curve). The Keynesian range represents the fiscalist or Keynesian view, the classical range the monetarist view, and the intermediate range the synthesist view. Privacy Policy 8. An increase in government expenditure shifts the IS curve to the right to E1,raises the interest rate to OR1 and income to OY1 by the full multiplier of the increase in govern­ment expenditure, as shown in Figure 14. The second case occurs when there is unemployment of resources in the economy and the LM curve slopes upward to the right. In the intermediate range, the initial equilib­rium is at С where the IS3 curve intersects the LM curve. Share Your PDF File This is the Keynesian liquidity trap situation in which the LM curve is horizontal, and the interest rate cannot fall below OR1 .An increase in the money supply shifts the LM curve from IM1 to LM2. The relative effectiveness of monetary and fiscal policy depends upon the shape of the IS and LM curves and the economy’s initial position. Thus under the Keynesian assumption of the liquidity trap, the horizontal portion of the LM curve is not affected by an increase in the money supply. An increase in govern­ment spending or a decrease in taxes shifts the IS curve upwards to IS which intersects the LM curve at E1 .This raises the national income from OY to OY1.The rise in the national income increases the demand for money, given the fixed money supply. Completely interest inelastic the us banks had made bad loans relating to real estate i.e., housing real. The market, the expansionary monetary policy is in­effective whether the is.! 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