Hicksian IS LM framework and Conditions of Policy effectiveness

Question

Consider closed economy described by IS-LM model:

Consider closed economy described by IS-LM model:

PE = C_a + MPC(Y - T) + I(r) + G

AE = Y

M/P= L(Y,r)

Case 1: Investment trap. Assume investments are nor sensitive to interest rate, Draw the graph for IS-IM model. What policy (monetary or fiscal) is effective and what policy is ineffective? Suggest any explanation why it may true.

Case 2: classical case. Now assume that investments are sensitive to interest rates, but money demand is not. Suggest any explanation why it may true. Draw the graph for IS-IM model. What policy (monetary or fiscal) is effective and what policy is ineffective

Answer 1

When the Investment Schedule is Insensitive to interest rates it and the IS curve become completely Vertical. A change in autonomous spending will shift the IS curve by the multiplier times the change in Autonomous spending. This will cause a movement along the LM curve to a new interest rate. However, interest rates don't matter. We will have a full multiplier effect. As Investment becomes more sensitive to interest rates the IS curve "flattens out". The Flatter the IS curve the more sensitive aggregate demand is to interest rates. A change in autonomous spending will shift the IS curve out just as far however, as interest rates rise, interest rate sensitive components of AD change in the opposite direction dampening the impacts of the change in autonomous spending and thereby making Fiscal Tools for demand management less effective. (less bang per buck). The central bank has the ability to affect the real economy by altering the money supply and interest rates. If Interest rates don't matter, neither does Monetary policy. 

General rule of thumb:

In terms of short run demand management, Monetary Policy like a flat IS curve and Fiscal policy likes a steep one.

The interest sensitivity of the demand for real balances affects the slope of the LM curve.

Remember the interest rate is the opportunity cost of holding Idle balances. If the demand for Real balances has a low interest sensitivity (money and bonds are not close substitutes) the bulk of the demand for real balances is for transactions purposes. This makes for a very steep LM curve. any increase in income will increase the transactions demand for money. With a fixed money supply, interest rates have to change a lot to clear the financial markets. A fiscal policy altering autonomous spend will shift the IS curve but have most of its impacts felt on interest rates with little impact on output. If the interest sensitivity demand for real balances is small, small changes in the money supply have large impacts on interest rates. 

The more sensitive the demand for real balance is to interest rate the less effective monetary policy becomes. It takes large changes in the money stock to alter interest rates. The limiting case is the Liquidity trap where interest rates are really low and altering the money stock leaves interest rates unchanged. This makes monetary policy ineffective.

Another Rule of Thumb; Monetary Policy likes a steep LM curve and Fiscal policy likes a flat one