Answer to Question #200443 in Macroeconomics for Muhammad Ali qaise

Question

Critically evaluate and explain with help of graph (s) that monetary policy or 

fiscal policy is appropriate when goods market is sensitive to rate of interest and 

money market is relatively insensitive to rate of interest.

Answer 1

if the LM curve is vertical , monetary policy becomes highly effective in raising equilibrium income [Fig. 3.35(a)]. Consequent upon an increase in money supply, the LM curve shifts from LM to LM₁. OY₂.The biggest effect of monetary policy can be felt if the IS curve is perfectly elastic [Fig. 3.35(b)].

On the other hand, if the LM curve is horizontal (pure Keynesian range) and if the IS curve is vertical, monetary policy becomes ineffective completely [Figs. 3.35 (c) and (d)]. Fig. 3.35 (c) says that a downward shift in the horizontal LM curve from LM to LM₁ along with the vertical IS curve, income remains unchanged at OY₁ while r declines to Or₂.

Thus, monetary policy does not have any influence in stimulating an economy in depression. Again, monetary policy fails to boost income/output of an economy if the positive sloping LM curve shifts from LM to LM₁, though interest rate declines from Or₁ to Or₂ following an increase in money supply(money market).

Therefore the effectiveness of fiscal policy depends on the slopes of the IS curve and the LM curve. The more interest-inelastic is the investment(money market), the more effective is fiscal policy (Fig. 3.36(b). Likewise, the flatter the LM curve, greater the effectiveness of fiscal policy (Fig. 3.36 (c). Fiscal policy is completely in­effective in Fig. 3.36(a).