Question

In: Economics

69. What does the effectiveness of fiscal policy at changing Y have to do with the...

69. What does the effectiveness of fiscal policy at changing Y have to do with the elasticity of money demand? Explain and diagrammatically represent your answer.

Solutions

Expert Solution

The effectiveness of fiscal policy is directly proportional to the elasticity of demand for money - that is, flatter the LM curve (greater the elasticity of demand for money) , greater is the effectiveness of fiscal policy.

Note that the LM curve represents locus of points considering demand for money as well as supply of money. Hence elasticity of demand directly determines the slope of LM curve (higher elasticity of demand for money implies flatter LM curve) and hence the effectiveness of fiscal policy. Another point to remeber moving forward is that an expansionary fiscal policy causes the IS curve to shift upwards to the right whereas a contractionary fiscal policy causes the IS curve to shift downwards to the left.

The anwer to this question can be understood with the help of the diagram below:

In the diagram above, an expansionary fiscal policy causes the IS curve to shift from IS to IS'. Consider two LM curves- LM1 and LM2? where LM2? is flatter (that is, LM curve with more elastic demand for money). A shift in the IS curve cause the equilibrium to shift from E to E1? for LM1 and E2 for LM2?. The x-axis represents Y (output/income). As YY2 (E to E1?) > YY1 (E to E2?), fiscal policy is more effective in case of LM2? (the flatter LM curve or higher elastic demand for money)

*Consider perfectly elastic demand for money implying horizontal LM curve implying fiscal policy is most effective.

* Inversely, fiscal policy is ineffective for a vertical LM curve (inelastic demand for money)

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