Answer to Question #278957 in Macroeconomics for Vageesha

Question

Why does a horizontal LM curve imply that fiscal policy has the same effects on the economy as those derived in Keynesian Model (horizontal AS)?

What are the implications of a horizontal LM curve for the link between goods market and asset market?

Under what circumstances might the LM curve be horizontal?

Answer 1

Fiscal policies are policy actions taken by the government to bring the economy back to equilibrium. The effectiveness of fiscal policy depends on the slope of the LM curve and the IS curve. It is more effective, the flatter is the LM curve, and is less effective when the LM curve is steeper. This is because fiscal policies lead to changes in IS curve, which gives the maximum result when LM is horizontal. Similarly, in cases where AS curve is horizontal, fiscal policies show the maximum result, as they affect the AD curve, and not AS curve.

A horizontal LM curve means that money demand depends only on the interest rate. It makes monetary policy ineffective. This is called the liquidity trap. In this case, money demand is totally interest elastic, and the parameter h in the money demand equation is assumed to be infinitely large.

LM curve is vertical when money demand is completely interest insensitive.