Question

Explain how the interest sensitivity of investment and interest sensitivity of money demand impacts the efficacy of monetary and fiscal policy.

Answer 1

The impact of monetary and fiscal policy in an economy depends to a great extent on the elasticity of investment to changes in the rate of interest and also interest sensitivity of money demand. This is because it determines the extent to which changes in the rate of interest will have an impact on investment demand and money demand in the economy. The greater the interest sensitivity of investment demand, the greater the impact of changes in the rate of interest on the investment demand and greater will be the speed with which the economy recovers. The lower the interest sensitivity of investment demand lower will be the impact of interest rate on investment demand and thus aggregate demand will change by a small amount.

On the other hand, interest sensitivity of money demand also impacts the monetary and fiscal policy in the economy. As interest sensitivity of moey demand increases, increase in interest rate will lead to fall in money demand by a greater amount and thus impact aggregate demand by a greater amount. On the other hand lower elasticity reduces the effectivess of fiscal amd monetary policy in the economy.