ISLM - Joint Equilibrium

Joint Equilibrium

• Product and Money Market

$$y=c(y-t(y))+g+i(r)$$ $$\frac{M}{p}=l(r)+\underset{+}{k(y)}$$

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Effectiveness of the policies

• $IS$ : Fiscal Policy
• $LM$ : Monetary Policy

Assumption

We assume a closed economy

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$$r\downarrow ⟹i\uparrow ⟹y\uparrow ⟹r\uparrow$$

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Scenario

What if your investment is not so sensitive?

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Effectiveness of the Fiscal Policy

taking into account the slope of the $LM$ curve

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• The effectiveness of the Fiscal Policy depends on whether the fiscal policy change is initiated at low or high level of output.
• The figure shows that the differing effect on $y$ for a given shift in $IS$ curve, depends on the slope of the $LM$ curve.
• At initial equilibrium of $y_0$ the $LM$ curve was relatively flat. This gives a large fiscal multiplier and thereby a bigger impact on the level of income.
• Whereas, at $y_2$, the level curve is relatively steeper^[nearly vertical] with the fiscal multiplier being extremely small. Thereby, lesser impact on the level of income.

Thus, the size of the fiscal policy multiplier depends on the slope of the $LM$ curve.

Expansionary Monetary Policy

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• The effect of the monetary policy would depend on the position of the economy and also the slope of the $LM$ curve itself.
• The shift in the $LM$ curve will have a greater effect on the Level of Income at high levels of income and rate of interest (i.e. $y_2$ and $r_2$) rather than, at the low levels (i.e. $y_0$ and $r_0$)
• The expansionary monetary policy will have a lesser impact on the level of income if the $LM$ curve is relatively flatter.
• Whereas, the monetary policy becomes highly effective when the $LM$ curve slopes steeper.

Thus, it is highly effective at high levels of income and rate of interest.

Summary

We can sum up the effectiveness of the policies as follows:

Summary

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To conclude, the fiscal policy becomes effective at lower levels of income whereas the monetary policy becomes effective at high levels of income