Question

a) Explain how, i) the interest sensitivity of private spending and ii) marginal propensity to consume, determine the slope of an iS curve. b) Suppose the Reserve Bank of Australia (RBA) is concemed about recession and wants to adopt an expansionary monetary policy. Explain, using the IS-LM diagram(s), how the effectiveness of monetary policy in increasing the output level may depend on the interest sensitivity of investment spending

Answer 1

a. The IS curve is given by the following equation:

$Y=C_0+c(1-t)Y+I(r)+G_0$

Differentiating completely, we get

1- C(1 -t) dr I '(r) dY

where, is the marginal propensity to consume, which is indirectly related to the slope of the IS curve and is the interest sensitivity of private investment (spending), which has an inverse relation with the slope of the IS curve.

b.

6 4 2 2 4 6

The red line is the LM curve. When both marginal propensity to consume and interest sensitivity of investment spending are very low (close to zero), the IS curve is vertical and expansionary monetary policy is ineffective in increasing output level.

.

6 4 2 0 2 4 6

When the marginal propensity to consume and interest sensitivity of investment spending both are very high, the IS curve is a horizontal line parallel to the x axis and an increase in money supply (monetary expansion) is very effective in increasing output level.