Suppose the investment is very sensitive to the interest rate.That is, the function I(r), used to...

Suppose the investment is very sensitive to the interest rate.That is, the function I(r), used to derive the IS curve, is very steep (that is, when we graph it with r on the vertical axis, it is very flat, almost horizontal). Graphically derive the IS curve in the closed economy. What can you say about the steepness IS curve? In this context, which policy do you think is likely to be more effective? Fiscal policy or monetary policy?

Expert Solution

When Investment is very sensitive to the interest rate, it implies that a small change in the interest rate will lead to a large change in Investment.

The slope of the Investment function will also impact the slope of the IS curve.

The IS curve will also be flat, i.e., a small change in interest rates will have a large change on the real GDP.

As shown in the graph below, at a lower interest rate, Aggregate Expenditure rises (due to higher consumption and investment). The equilibrium GDP rises.

As the IS curve is steep, a small cut in interest rates, from r to r", increases the GDP by a large amount, Y to Y".

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When the IS curve is flat, monetary policy is more effective.

Monetary policy will work on the interest rates, and a small change in interest rates will have a large change on GDP.

Rahul Sunny answered 2 years ago

Suppose the investment is very sensitive to the interest rate.That is, the function I(r), used to...

Suppose the investment is very sensitive to the interest rate.That is, the function I(r), used to derive the IS curve, is very steep. Graphically derive the IS curve in the closed economy. What can you say about the steepness IS curve? In this context, which policy do you think is likely to be more effective? Fiscal policy or monetary policy?

Suppose the investment is very sensitive to the interest rate.That is, the function I(r), used to...

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