This case is depicted in Fig. Before publishing your Articles on this site, please read the following pages: 1. In the Keynesian range, monetary policy is ineffective whether the IS curve is elastic (ISF) or inelastic (ISs). In between these two segments of the curve is “the intermediate range”. There are many means for the Fed to implement policy. The large increase in the interest rate reduces private investment despite increase in government expenditure which ultimately brings a small rise in income OY1. It is important to explain to what extent monetary policy is effective in influencing level of national output. This means rise in interest rate has completely wiped out the expansionary effect on the level of real national income by crowding out private investment. When the steep LM1 curve shifts to the right to LMs, the new equilibrium is set at E2 .As a result, the interest rate falls from OR to OY2 and income rises from OY to OY2 .On the other hand, the flatter is the LM curve, the less effective is monetary’ policy. Welcome to EconomicsDiscussion.net! When the government expenditure increases for an expansionary fiscal policy, the IS5 curve shifts upward to IS6. This case bridges the gap between the Keynesian and classical views. If the interest rate had not changed with the increase in government expenditure, income would have risen to OY1 level. Now take the slope of the IS curve. Content Filtrations 6. There is an ongoing debate about the inherent effectiveness of monetary policy and its fundamental limitations. The more instruments available to implement policy, the greater the likelihood that supposedly inflationary policies can be offset through subtle means that are difficult to perceive. In the US banks had made bad loans relating to real estate i.e., housing. This paper considers the significance of this shift in the emphasis of monetary policy, questions its effectiveness, and explores the role of fiscal policy. Therefore, to earn some return on their excess cash reserves due to easy monetary policy, some banks opted for investing in government securities beyond what was required under statutory liquidity ratio (SLR). At the other extreme is the perfectly horizontal LM curve where fiscal policy is fully effective. This is depicted in Fig. If due to risk aversion banks do not lend for private investment, the link in transmission mechanism that involves more private investment in response to lower interest rate breaks down to give boost to real national income. Share Your Word File On the other hand, it intersects the steeper LMs curve at E1 which determines OY1 income and OR1interest rate. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. Disclaimer Copyright, Share Your Knowledge Second, fiscal policy is more effective if monetary policy is accommodative. The effect of increase in money supply on aggregate output in case of horizontal LM curve is a bit complicated to show diagrammatically through IS-LM curve model. On the other hand, if the LM curve is vertical, monetary policy is highly effective because the demand for money is perfectly interest inelastic. There has also been a general shift toward the adoption of inflation targets and the use of monetary policy to target inflation. There has also been a general shift towards the adoption of inflation targets and the use of monetary policy to target inflation. Now consider the intermediate range when the initial equilibrium is at В where the IS2 curve intersects the LM1 curve, and the income level is OY2 and the interest rate is OR1.The increase in the money supply shifts the LM1 curve to LM2 position. However, there is further effect of expansionary fiscal policy. Suppose the economy is in equilibrium at point E with OY income and OR interest rate. Image Guidelines 5. That which is held for speculative purposes is not invested by wealth holders and remains with them in the form of idle balances. The same result follows in the case of the shifting of an inelastic IS curve. Fiscal policy is completely ineffective, if the LM curve is vertical. NOW take the slope of the IS curve. This paper empirical study the effectiveness of monetary and fiscal policy instruments in stabilizing Nigerian economy from 1981 - 2015. However, the ineffectiveness of monetary policy in case of the liquidity trap situation can be easily understood if we take the case of relatively flat LM curve (which can be considered as proxy for completely horizontal LM curve) caused by liquidity trap. But due to some reasons, the economy’s growth rate has slowed down. This brings about new equilibrium at В where the IS2 curve cuts the LM curve. This happens when changes in rate of interest have insignificant effect on autonomous planned spending, especially investment expenditure. Now suppose the government adopts expansionary fiscal policy and increases its expenditure shifting the IS curve to IS2. But in the intermediate range both monetary and fiscal … Monetary policy involves decisions taken by a government or central bank to attempt to influence the economy by influencing the availability of money and the cost of credit. Suppose the central bank adopts an expansionary monetary policy whereby it increases the money supply by open market operations. This is shown in Figure 11 where the horizontal LM curve is intersected by the IS curve at E which produces OR interest rate and OY income. The flatter IS curve means that the investment expenditure is highly interest elastic. The Synthesist View: Three Range Analysis. A steeper LM curve means that the demand for money is less interest elastic. Figure 7 shows that with the increase in the money supply, the LM curve shifts to LM1 .But even with no change in the interest rate OR, there is a large change in income from OY to OY1 This makes monetary policy highly effective. In both these forms of fiscal stimulus, the IS curve shifts to the right. Since with a shift in IS curve to IS2 aggregate demand increases along an upward sloping short-run aggregate supply curve, this will lead to the rise in price level resulting in decline in real money supply. The Keynesian range represents the fiscalist or Keynesian view, the classical range the monetarist view, and the intermediate range the synthesist view. When the money supply is increased, it is an expansionary monetary policy. First, consider the Keynesian range where the LM curve is perfectly elastic. On the other hand, in the classical range, monetary policy is effective and fiscal policy is ineffective. Expansionary fiscal policy with its multiplier effect shifts IS curve to IS2 equal to the horizontal distance E1 H. With the given LM curve and the new IS2 curve the new equilibrium is reached at point E2 and, as will be seen from the Figure 20.16, the national income increases from Y1 to Y2, the income equal to KH has been wiped out due to crowding-out effect of rise in interest rate from r1 to r2. On the other extreme is the vertical IS curve which makes fiscal policy highly effective. Similarly, the steeper curve IS2 is shifted to ISs with the increase in government expenditure and the new equilibrium with LM curve at point E2 leads to OR2 interest rate and OY2 income level. In this case fiscal stimulus through increase in government expenditure will raise interest rate but level of real national income will also increase. It helped to stabilise financial markets and avoid deflation. As a result, increase in money supply causing lower interest rates does not lead to the increase in real national income. When the LM curve shifts to the right to LM1 with the increase in money supply, it intersects the flatter curve ISF at E2 which produces OR2 interest rate and OY2 income. Both the curves intersect at В whereby the interest rate is lowered to OR1 and the level of income rises to the full employment level OYF. This happened in the US in 1991 and then in 2008-09 and 2009-10, when global financial crisis occurred. If the LM curve is horizontal, monetary policy is completely ineffective because the demand for money is perfectly interest elastic. This is shown in Figure 10 where the level of income remains unchanged. In order to overcome this, more investment is required to be made in the economy. Recall that the IS curve describes equilibrium in the goods market. The third case occurs when there is unemployment in the economy so that there is possibility of increases in output as a result of increase in aggregate demand. Instead of lending for private spending and investment, banks purchased government securities such as treasury bills which are quite safe investment for banks. The second factor causing ineffectiveness of monetary policy occurs in the third step of transmission mechanism, namely, changes in aggregate spending or demand in response to changes in interest rate. The Fed and the government use different tools to steer the economy. In India too, when in 2008-09 the Reserve Bank of India lowered its repo rate and cash reserve ratio (CRR) for the banks, they were not much enthusiastic for lending to private firms for fear of default by them in repaying the loans. If the IS curve is vertical monetary policy is completely ineffective because investment expenditure is completely interest inelastic. This shifts the IS curve to the left. It shows that with the increase in the money supply the rate of interest falls from OR3 to OR2 and the income level rises from OY2 to OY3. When the IS curve shifts upwards to IS1with the increase in government expenditure, its impact on the national income is more with the flatter LM curve than with the steeper LM curve. All of these tools can be controlled actively. Fiscal policy is explained in Figure 16 in which the three range LM curve is taken along with six IS curves that arise after increase in government expenditure in the case of the Keynesian, intermediate and classical ranges. Expansionary fiscal policy may be either in the form of increase in government expenditure or cut in taxes. This has the effect of raising the income level by less than the increase in the money supply. Finally, the aggregate output adjusts to the changes in aggregate demand. This reduces the interest rate from OR to OR1 thereby increasing investment and national income. An increase in government expenditure shifts the IS curve to the right to E1,raises the interest rate to OR1 and income to OY1 by the full multiplier of the increase in government expenditure, as shown in Figure 14. Economists have explained the effectiveness of monetary and fiscal policies in three ranges in order to reconcile the extremes of the Keynesian and monetarist (or classical) views. We investigate the effectiveness of Japanese fiscal policy over the 1976–1999 period using a structural VAR analysis of real GDP, tax revenues, and public expenditures. On the Effectiveness of Monetary Policy and Fiscal Policy. In the intermediate range, the initial equilibrium is at С where the IS3 curve intersects the LM curve. 20.13 increase in the government expenditure causing a shift in the IS curve to the right to IS2 position. It may be noted that in 2008-09 and 2009-10 when due to global financial crisis, India faced the problem of large slowdown of the economy, the Indian government adopted fiscal stimulus measures such as raising its expenditure through borrowing on a large scale from the market and cut rates of many indirect taxes to prevent sharp slowdown of the Indian economy, the Reserve Bank of India adopted accommodative monetary policy so that rate of interest does not rise. This enables us to question the effectiveness of monetary policy, and to explore the role of fiscal policy. Second, given a fixed money supply, a part of available transactions are held as idle balances by wealth holders which raise the interest rate. The liquidity trap is a situation in which the public is prepared at a given rate of interest to hold whatever money is supplied. The study examines the effect of monetary and fiscal policy on inequality conditioned on low and high uncertainty. We have seen above that the increase in real national income (i.e., multiplier effect) as a result of expansionary fiscal policy (e.g., increase in government expenditure) depends on interest elasticity of demand for money (that is, slope of LM curve). 20.14 where a vertical LM curve is drawn at the level of national income Y1. The increase in money supply shifts the LM1 curve to the right to LM2 position. Let us take another situation when the economy is at the full employment level of income OYF where the IS curve intersects the LM curve at point E in Figure 19. Transmission of changes in money supply, say through open market operations, runs as follows, In the first step increase in money supply following the expansionary monetary policy leads to the fall in rate of interest. 20.17 in which it will be seen that initially equilibrium is at point E1 where IS1 and LM1 curves intersect determine Y1 level of income and r1 rate of interest. The increase in the interest rate to OR1 reduces large private investment so that the rise in income is smaller. The main part of fiscal policy in order to increase growth is expansionary fiscal policy. 20.15 where initially IS1 and LM1 curves intersect at point E1 and determine level of national income Y which is a full-employment level. Before publishing your articles on this site, please read the following pages: 1. First, the increase in income resulting from a rise in government expenditure occurs because additional money balances are available for transactions purposes. This new IS2 curve intersects the given steep LM curve at point E2 and, as will be seen from Figure 20.12, rate of interest rises to r2 and the real national income increases from Y1 to Y2. As a result, level of national income remains unaffected. Thus fiscal policy is more effective, the steeper is the IS curve and is less effective in the case of the flatter IS curve. Policy measures taken to increase GDP and economic growth are called expansionary. In this case the magnitude of fiscal multiplier is quite large. Both fiscal and monetary policy can be either expansionary or contractionary. Now suppose under the expansionary fiscal policy the government increases its expenditure so that there is a shift in the IS1 curve to the right to IS2. On the other hand, in the classical range, monetary policy is effective and fiscal policy is ineffective. This is because the classical case relates to a fully employed economy where the increase in government expenditure has the effect of raising the interest rate which reduces private investment. Before we discuss them, we study the effectiveness of monetary and fiscal policy in terms of shape of the IS curve and the LM curve. A small fall in the interest rate leads to a smaller increase in investment and income. Figure 8 illustrates an expansionary fiscal policy with given IS and LM curves. The IS curve represents fiscal policy and the LM curve monetary policy. A large fall in the interest rate leads to a higher increase in investment and in national income. Wealth holders then find other assets more attractive than securities essays, articles and other allied information by! 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