Answer to Question #257805 in Macroeconomics for mr nobody

Question

With the use of a graph explain the vertical and horizontal cases of the LM curve and show which policy is ineffective under each case.

Answer 1

The IS-LM model shows the interaction between the goods market and the money market. The model shows the combination of output and interest rate at which the goods market and the money market are in equilbrium.

The IS curve illustrates the combinations of interest rate and output at which the total investment is equal to the total saving. The LM curve represents the combinations of interest rate and output at which the money demand and money supply are equal. The intersection of the two curves shows the combination of interest rate and output at which the money market and goods market are in balance.

When the LM curve is vertical, the fiscal policy is ineffective. An expansionary fiscal policy of increase in government expenditure or tax cuts will have no impact on the national income when the LM curve is vertical. The expansionary fiscal policy will shift the IS curve to the right. The equilibrium interest rate in the economy will increase, however, the output will remain the same. 

In the figure below, the initial equilbrium is at point E1 where the IS curve IS1 intersects the LM curve. The equilibrium interest rate is r1 and the output is Y1. An expansionary fiscal policy will shift the IS curve to the right. The new equilbrium is at point E2 where the new IS curve IS2 intersects the LM curve. The equilbrium interest rate has increased to r2, but the output remains at Y1.

When the LM curve is horizontal, the monetary policy is ineffective. A horizontal LM curve indicates that the money demand is extremely sensitive to the change in interest rate. An expansionary monetary policy will not shift the LM curve and the interest rate and the output will remain the same. This is a case of a liquidity trap.