Question

In an IS-LM model, if we assume that money demand is completely insensitive to changes in the interest rate

A.) interest rates cannot be lowered by fiscal policy

B.) fiscal policy can neither change the level of output nor the composition of GDP

C.) monetary policy can change income

D.) monetary policy is totally ineffective in changing the rate of interest

E.) the economy cannot be stimulated by fiscal or monetary policy

Answer 1

If the demand for money is interest inelastic the LM curve will be a vertical straight-line. The demand for money does not change with the change in supply of money. A given amount of money is demanded irrespective of changes in money supply. If the demand for money is interest elastic an increase in money supply lowers the interest rate which will increase the demand for money and thereby the rate of interest. Thus in the context of interest elastic demand for money a decrease in the rate of interest through an increased money supply is offset by and increased demand for money and resulting higher rate of interest. Thus a monetary policy is ineffective in changing the level of output and income.

But if the demand for money is interest inelastic an increased money supply lowers the interest rate and which will increase the investment demand, output and income.

Answer: C) Monetary policy can change the level of income.