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effectiveness of monetary policy and fiscal policy

At the other extreme to the right, the LM curve is perfectly inelastic. In between these two segments of the curve is “the intermediate range”. When there is full employment in the economy, increase in aggregate demand leads to the rise in price level as the economy moves up along an upward-sloping short-run aggregate supply curve. Policy measures taken to increase GDP and economic growth are called expansionary. Recall also that fiscal policy, the toolbox of the government, includes changing both taxes and government spending. This increase in rate of interest causes private investment to fall that is, increase in government expenditure crowds out some private investment. 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. The elastic curve ISF, shifts to ISF1 and income rises from OY1 to OY2 in Figure 17. First, the increase in income re­sulting from a rise in government expenditure occurs because additional money balances are available for transactions purposes. This is illustrated in Figure 18 where the economy is in the initial situation at A on the basis of the interaction of IS1and LM1 curves. In our previous Fig. The below mentioned article provides notes on effectiveness of monetary policy and fiscal policy. But in the intermediate range both monetary and fiscal policies are effective. Copyright 10. This is because when the demand for money is less elastic to a change in interest rate, an increase in the money supply is more powerful in the bring­ing about a large fall in interest rate. If the IS curve is vertical monetary policy is completely ineffective because investment expendi­ture is completely interest inelastic. 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. 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. Now suppose the Central Bank of the country expands money supply equal to the horizontal distance EH shifting the LM curve to LM2. 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. Now, fiscal stimulus by the government shifts the IS curve to IS2 and given the LM1 curve, equilibrium will be at point E2 where rate of interest rises to r2 which would crowd out private investment. It is important to explain to what extent monetary policy is effective in influencing level of national output. With the increase in the money supply, the LM curve shifts to the right to LM1 in Figure 6, the interest rate falls from OR to OR1 but investment being completely interest inelastic, the income remains unchanged at OY. Fiscal policy, properly coordinated with monetary and financial stability policies, should thereby be restored to its proper upgraded role in terms of This is shown in Figure 10 where the level of income remains unchanged. It rises to OK, but there is no change in interest rate. In this case crowding-out of private investment equals the increase in government expenditure times its multiplier (i.e. But in the intermediate case, the increased money supply is partly absorbed for speculative purposes and partly for transactions purposes. 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. In this context, it is worth mentioning the policy of ‘quantitative easing’ (QE) which the Federal Reserve of the US is pursuing to revive the American economy under the leadership of its governor Ben Bernanke. We examine these questions from the point of view of the "new consensus" in monetary economics and suggest that it is rather limited in its analysis. Thus in the Keynesian range, the fiscal policy is very effective. 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. This is depicted in Figure 5 where the original equilibrium is at point E with OR interest rate and OY income level. This is because with fixed money supply at low levels of interest rate and income, there is a lot of idle money with the wealth holders. Thus the increase in income equal to E1 E3 or Y1 Y2 that occurs equals the increase in government expenditure times the Keynesian multiplier (i.e., ∆G. However its actual effectiveness at meeting this objective is arguably not that good for a number of reasons which will be discussed in this essay. We examine these questions from the point of view of the "****new consensus" in monetary economics and suggest that it is rather limited in its analysis. This is shown by shifting the LM curve to the left. Now, the rise in price level, nominal money supply remaining constant, reduces the real money supply, that is, M/P decreases. Disclaimer Copyright, Share Your Knowledge Our mission is to provide an online platform to help students to discuss anything and everything about Economics. On the other hand, in the classical range, monetary policy is effective and fiscal policy is ineffective. An horizontal IS curve means that investment expenditure is perfectly interest elastic. 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. Suppose the economy is in equilibrium at point E with OR interest rate and OY income. Plagiarism Prevention 4. Suppose the government expenditure is increased. When the interest rate does not rise the level of investment remains the same as before and the increase in income is equal to the full multiplier times the increase in government expendi­ture. This shifts the IS curve to the right. 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. Thus the monetary policy is highly effective in the classical range when the economy is at high levels of income and interest rate and utilises the entire increase in the money supply for transactions purposes thereby raising national income by the full increase in the money supply. The data were sourced from Central Bank of Nigeria, National Bureau of Statistics and World Development Index (WDI). However, in a fully employed economy crowding out of fiscal stimulus occurs through a different route. When the LM curve is more steep, that is, when interest responsiveness of demand for money is less, a given increase in government expenditure will have large crowding-out effect as shown in Fig. The IS curve intersects the LM curve in the flat range at A with little effect on the interest rate, and consequently on investment and income. It will be seen from the new equilibrium at point B that the interest rate falls only slightly and as a result real national income hardly increases to have any impact on the recessionary conditions. However, there is further effect of expansionary fiscal policy. This enables us to question the effectiveness of monetary policy, and to explore the role of fiscal policy. This study investigates the comparative effect of fiscal and monetary policy on economic growth in Pakistan using annual time series data from 1981 to 2009. The same result follows in the case of the shifting of an inelastic IS curve. In general, fiscal policy “will be more effective the closer equilib­rium is to the Keynesian range and less effective the closer equilibrium is to the classical range.”. Considerably in importance, with the latter is rarely mentioned overheated\ '' economy ( usually when inflation too! 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