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“Expansionary fiscal policy is more effective in influencing the aggregate income level when investment is interest-elastic”....

“Expansionary fiscal policy is more effective in influencing the aggregate income level when investment is interest-elastic”. Do you agree with this statement? Why and why not? Explain your answer based on IS-LM framework.

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Answer #1

This statement is correct

When the investment is interest elastic it implies that small changes in interest rate bring greater changes in the investment. This implies that the IS curve is relatively flatter. Expansionary fiscal policy increases aggregate expenditure and shifts the IS curve to the right. There is a very small increase in the rate of interest but a greater increase in the income level. This happens because IS curve is flatter. This shows that expansionary fiscal policy is more effective when investment is interest elastic.

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