Question

When investors are very pessimistic about the future, investment is not sensitive to interest rates. How does this affect the IS curve? If the government intends to stimulate the economy, which policy (monetary/ fiscal) will be effective in this case and which will be not? Explain using the LM/IS diagram.

Answer 1

Slope of IS curve depends on interest-sensitivity of investment. When investment is not sensitive to interest rate, the IS curve is vertical. When IS curve is vertical, monetary policy is completely ineffective because a change in interest rate caused by monetary policy will have no impact on investment demand. However, fiscal policy will be fully effective. So, if government increases spending or lower taxes (therefore increasing budget deficit), the resulting deficit financing by borrowing will increase interest rate but will leave investment demand unchanged, so crowding out effect will be absent. Fiscal policy will be fully effective in changing aggregate demand.

In following graph, IS0 & LM0 are IS & LM curves intersecting at point A with interest rate r0 & output Y0. Since IS is vertical, even if money supply increases (LM shifts right to LM1, increasing interest rate to r1) or decreases (LM shifts left to LM2, decreasing interest rate to r2), output remains unchanged at Y0. But if government sending rises or taxes fall, IS shifts rightward to IS1 and output rises by full extent to Y1.