Question

Discuss effectiveness of monetary and fiscal policy by using IS-LM model

Answer 1

The effectiveness of the monetary policy depends on two processes; one when expansionary policy increases money supply which shifts LM curve to the right such that rate of interest falls and second is the impact on the goods market when interest rate falls then investment and aggregate spending rises which increases output. The effectiveness is hampered by the liquidity trap which is represented by a flat LM curve and monetary policy is ineffective. Another case is when the IS curve is flat in the classical case, a right shift in the LM curve is ineffective in increasing output and only rate of interest rises.

The effectiveness of fiscal policy; expansion of fiscal policy is represented by increase in government spending or cut in taxes shifts IS curve to the right but the increase in the output depends on the responsiveness of interest rate to the money demand. Lower the responsiveness, lower will be the effectiveness of the fiscal policy. In case of no crowding out, when the LM curve is flat then increase in the IS curve will increase output to the desired levels.