Question

Please discuss the implications of followings in terms of shape of IS & LM curves and the impact of fiscal policy (IS shifts) and the monetary policy (LM shifts). (Hint: the shape of IS &LM curves can be evaluated in terms of its intercept and the slope)

i) as the investors become less sensitive to interest rate ?(Hint: Consider the Investment function as I = I0 – b.i, where i is the interest rate and b represents the investors’ sensitivity to interest rate change) ?

ii) as the marginal propensity to consume increases ?

Answer 1

Suppose there is a two sector economy:

C= a+cY

I= I0-bi

Where C is consumption expenditure

I is investment expenditure

a is autonomous consumption

c is Marginal propensity to consume

Y is income

I0 is autonomous investment

b is interest sensivity

i is interest rate

IS curve:

Y=C+I

Y=a+cY+I0-bi

Y-cY=a+I0-bi

Y= (a+I0-bi)/(1-c)

dY/di= -b/(1-c) Slope of IS

i) As the investors become less sensitive to interest rate, it means that due to change in interest rate there will be a very small change in investment as well as income. So it cause IS curve to be more steeper.

Take a extreme condition where b=0 and b= infinity.

In case where b=0 IS will be Vertical(steeper)

So a change in monetary policy does not have any effect on output and fiscal policy is fully effective

In case where b=infinity IS will be horizontal(flatter)

So a change in monetary policy have full impact on output but the effectiveness of fiscal policy decreases

ii) As the marginal propensity to consume increases,it cause IS curve to be more flatter.

In case where MPC=1 IS will be Vertical(steeper)

So a change in monetary policy does not have any effect on output and fiscal policy is fully effective

In case where MPC=0 IS will be horizontal(flatter)

So a change in monetary policy have full impact on output but the effectiveness of fiscal policy decreases