Question

Monetary policy will have different impact on the equilibrium rate of interest and

GDP. Try to draw three different IS curves with different slopes and show

a) The different impact of the same easy money policy on interest rate and GDP in these different IS curves

b) Monetary policy is most effective under what conditions ( which IS curve). Why ?

c) What determine the slopes of IS curve. Review chapter 14 on sticky price and flexible price model to answer the percentage distribution of both types of firms ,i.e. s vs ( 1-s) under different IS curves( hint : refer to the equations on. P. 408 and p. 411 that

P=EP+{( 1-s)/a/s} ( ( Y-Y bar) p. 408

Y= Y bar + alpha ( P-EP). P. 411

Answer 1

Three different IS curves with different slopes have been shown in the graph as above.

a) In the graph above, IS1 curve is steeper, IS2 is relatively flatter and IS3 has slope 0 and is horizontal. The same easy monetary policy has led to shift of LM curve from LMo to LM1. However, due to the different slopes of IS curves as show, the resulting imoact on interest rate and GDP is different. As can be seen above, in presence of a steep IS curve i.e, IS1 , monetary policy will be less effective as there is increase in GDP only from Y1 to Y1'. whereas, in case of a flatter IScurve in which investment demand is more interest elastic, the GDP has increased from Y2 to Y2' with a relatively less fall in interest rate from i2 to i2' as compared to the fall in interest rate from i1 to i1'.

b) The monetary policy is most effective when the slope of IS curve is 0. i.e, the IS curve is completely flat and horizontal to the x-axis. in such a case, there has been no fall in interest rate with monetary policy in action and thus, the interest rate remained at i3 preventing any possibility of a crowding out effect and so, there has been increase in GDP from Y3 to Y3' , which is the maximum.

c) The slope of IS curve is determined by interest sensitivity of investment and the value of the multiplier.The slope of IS curve is given by:

slope = di/dY = - 1 / ( G*b)

here, G = Multiplier = 1/(1-mpc)

  b = Interest sensitivity of investment, higher sensitivity of investment to interest rate, higher will be the value of b.