Deck 24: Money and Economic Stability in the Islm World

Question 1

Explain why monetarists would argue that the slope of the LM curve determines only part of the real crowding-out effect associated with fiscal policy.

Answer 1

Monetarists argue that only when the LM curve is horizontal that the fiscal policy if effective and there is no crowding out. When the LM curve is vertical, the fiscal policy is ineffective and thus crowding out occurs. The LM curve becomes horizontal when interest rates cause no change in the demand for money. Under the horizontal LM curve, the impact would be focused completely on GDP, while interest rates would be unaffected. Thus crowding out does not occur.

Question 2

Explain verbally or geometrically how the slope of the LM curve helps determine whether shifts in autonomous investment cause small or large fluctuations in GDP.

Answer 2

The LM curve can either steep or flat. The interest rates fluctuate more when the LM curve is steep, which causes less fluctuation in GDP. A big change in interest rates will cause a big change in investment spending, which will balance out a large adjustment in autonomous investment. The interest rates fluctuate less when the LM curve is flat, which causes more fluctuation in GDP. A small change in interest rates will cause a small change in investment spending, which will balance out a minor adjustment in autonomous investment.

Question 3

Define the natural rate of interest and show how price flexibility prevents changes in the money supply from influencing the natural rate.

Answer 3

Natural rate of interest is the rate at which savings and investments are equivalent. That is, borrowers and savers influence the natural rate of interest, at full employment. Changes in money supply can affect nominal rates, when there is an expectation of inflation. The natural rate cannot be influenced by changes in money supply. Price flexibility causes the interest rate to decrease while money supply increases, and vice versa. Next, an increase in prices will cause money supply to decrease, and vice versa. Thus, money supply and prices offset each other in this situation, making natural rate independent of money supply changes.

Question 4

In ISLM analysis, is there a tradeoff between the volatility of GDP and the volatility of interest rates Could high amounts of Interest rate volatility reduce duce GDP growth How

Question 5

Discussion question: Which do you think is the more powerful force in stabilizing the economy at or near full employment, flexible wages and prices or flexible interest rates