In the intermediate range, monetary policy is less effective when the ISS1 curve is inelastic because the rise in income in this case is Y2Y3 w here as in the case of the elastic curve ISF1, it is more effective, the rise in income being Y2F5 (>Y2Y3). For an expansionary fiscal policy, the gov­ernment increases its expenditure or/and reduces taxes. First, the increase in income re­sulting from a rise in government expenditure occurs because additional money balances are available for transactions purposes. This is depicted in Figure 13 where LM curve intersects the IS curve at E. An increase in government expenditure has no effect on the interest rate OR and hence on the income level OY. Keywords: Fiscal policy, monetary policy, Taylor rule JEL classification: E63, H63 1 The authors thank Tracy Chan, Emese Kuruc, Lillie Lam and Alan Villegas Sanchez for providing research assistance. A large fall in the interest rate leads to a higher increase in investment and in na­tional income. Consider the classical range where LM curve is perfectly inelastic. This shifts the IS curve to the left. As a result, level of national income remains unaffected. This level can be maintained by the present monetary-fiscal policy mix because the lower interest rate would keep large investment spending in the economy and reduced government expenditure or high taxes would control inflation. The government follows a contractionary fiscal policy by reducing its expenditure or/and increasing taxes. An increase in govern­ment spending or a decrease in taxes shifts the IS curve upwards to IS which intersects the LM curve at E1 .This raises the national income from OY to OY1.The rise in the national income increases the demand for money, given the fixed money supply. When the central bank buys securities in the market, the security prices are bid up and the rate of interest falls. The increase in the interest rate to OR1 reduces large private investment so that the rise in income is smaller. This situation occurs when business firms are so pessimistic about the future prospects of earning profits that they are reluctant to undertake any further investment in response to lower interest rate. Monetary and fiscal policy tools are used in concert to help keep economic growth stable with low inflation, low unemployment, and stable prices. This is the Keynesian liquidity trap situation in which the LM curve is horizontal, and the interest rate cannot fall below OR1 .An increase in the money supply shifts the LM curve from IM1 to LM2. 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 find that population aging weakens the effectiveness of fiscal stimulus. Both fiscal and monetary policy can be either expansionary or contractionary. 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. The normal case has already been explained in Figure 11. The elastic curve ISF, shifts to ISF1 and income rises from OY1 to OY2 in Figure 17. With the net increase in national income from Y1 to Y2 resulting from the shift in IS curve from IS1 to IS2 the level of saving will increase. WORKING PAPER NO: 1064 Fiscal Policy : The size of the fiscal policy (FP) multiplier or the effectiveness of fiscal policy depends on whether FP change is initiated at a low or high level of output relative to full employment output. The steeper is the IS curve, the more effective is fiscal policy. With the given IS curve the new equilibrium is at point B. If the economy is in the Keynesian range, monetary policy is ineffective and fiscal policy is highly effective. TOS4. In the second step of transmission mechanism, fall in rate of interest causes increase in total spending or aggregate demand (especially, investment expenditure). Starting from the left it is perfectly elastic. 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. But in the case of the flatter curve LMF the rise in the interest rate to OR2 is relatively small. In this case of sufficient monetary accommodation, rate of interest does not rise, and therefore there is no crowding-out effect on private investments, the expansionary fiscal policy brings about increase in national income equal to increase in government expenditure times the Keynesian multiplier (i. e., ∆G x 1/1 – MPC). Accordingly, the government reduces its investment expenditure or/and increases taxes so that the IS curve shifts to the left to IS1. This brings about new equilibrium at В where the IS2 curve cuts the LM curve. Recall that the IS curve describes equilibrium in the goods market. Thus, “Monetary policy is accommodating when in the course of fiscal expansion, the money supply is increased to prevent interest rates from rising”. 20.10. where a relatively flat LM1 curve intersects the given IS curve at front E determines rate of interest r1 and level of real income Y1. Welcome to EconomicsDiscussion.net! If the economy is in the Keynesian range, monetary policy is ineffective and fiscal policy is highly effective. The normal case has already been explained in Figure 3. Figure 4 shows that when the vertical LM curve shifts to the right to LM with the Increase in the money supply, the interest rate falls from OR to OR1which has no effect on the demand for money and the entire increase in the money supply has the effect of raising the income level from OY to OY1. Privacy Policy 8. 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. But the relative effectiveness of monetary policy depends on the shape of the LM curve and the IS curve. Monetary policy is explained in Figure 15 where the three-range two LM curves LM1 and LМ2 are shown with three IS curves. The normal case has already been explained in terms of Figure 4. The shifting of the inelastic curve ISS1 to ISS0 shows the increase in income from OY3 to OY4. In order to overcome this, more investment is required to be made in the economy. 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. Suppose the economy is in equilibrium at point E with OY income and OR inter­est rate. Second, given a fixed money supply, a part of available transactions are held as idle balances by wealth holders which raise the interest rate. Monetary policy is, therefore, totally ineffec­tive in the Keynesian range. 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. When an increase in the money supply low­ers the interest rate even slightly, private investment also increases, by a large amount, thereby raising income much. 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. 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. 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. 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