Question

Suppose that the economy is in a recession and assume that the IS curve is relatively steep while the LM curve is relatively flat. Without complications from other matters, which macro policy would be more effective in the very short run to lift the economy out of recession, fiscal or monetary? Illustrate your answer in a diagram.

Answer 1

If the above situation prevails, appropriate policy is fiscal policy.The effect on income of fiscal policy action is the largest when LM schedule is relatively flat.

lt indicates that fiscal policy is most effective when the interest rate inelasticity of money demand is high making the LM schedule relatively flat; the reason for this concern of the interest-rate adjustment on investment after fiscal policy shift.

Lets explain the situation with the help of a diagram. Suppose we use, expansionary Monetary policy, it shifts LM to LM1. Intersection of LM1 with IS yields an income of Y1 which is less than Y* full employment level of income

On the other hand, if we use expansionary fiscal policy ls shift to IS1 . It's intersection with LM rises income to Y* which is greater than Y1 and represents full employment level

Thus fiscal policy is more effective.