Question

3. After having defined the diagram and discuss the impact on the equilibrium ineffectiveness of this policy IS and LM curves, show in a diagram the general equilibrium position. Then show on the same position of a monetary expansion. Explain also possible cases of

Answer 1

IS curve shows combination of output and interest rate when goods market is in equilibrium. IS curve is downward sloping in the diagram . LM curve shows combination of output and interest rate when money market is in equilibrium. LM curve is upward sloping in the diagram . Equilibrium occurs when the tow curves intersect at point E where equilibrium output = OY* and equilibrium interest rate = OR*

Incase of expansionary monetary policy the LM curve will shift to the right such that LM' intersects the IS curve at point F where new equilibrium output has increased to OY1 and new equilibrium interest rate has decreased to OR1.Expansionary policy means increase in money supply, so given the initial IS curve , interest rate must fall to make people increase their spending and therefore causes the output to increase .

An expansionary monetary policy is completely ineffective when the LM curve is horizontal i.e people are willing to hold any amount of money at the going interest rate  .In this case an expansionary monetary policy will cause no shift in the LM curve so equilibrium occurs at point G only where equilibrium output = Oy2 and equilibrium interest rate = OR2