Question

In the short-run, the effect of an expansionary monetary policy on the output level is very large when money demand is relatively insensitive to the changes in the interest rate. Do you agree or disagree with this statement? Explain your answer using appropriate diagram(s).

Thanks.

Answer 1

Agree

Expansionary monetary policy is maximum effective when LM curve is relatively more steeper

As eqn for LM : M^{​​​​​​d}= kY - hi

so slope of LM: k/h

h : interest rate sensitivity of money demand

thus as h tends to zero , then LM tends to vertical .

As as h falls, LM curve becomes steeper , slope rises.

Bcoz as money supply rises , then LM shifts to right , then Y rises & interest rate falls ., Now rise in interest rate has very little effect on money demand,

as i falls, so Investment rise & so Y rise, since money demand is very less affected, so very large cut in i is required to bring back money market in the eqm,

so large increase in Investment spending, so maximum rise in Y, & so maximum effect on Y

(as money supply rise , money market is in dis-equilibrium.

so money demand should also rise , thus interest rate should fall)