• Effectiveness of monetary policy has three aspects: technical, theoretical and practical

• Technically, the IS and LM curves serve as analytical tools for explaining the effectiveness of monetary policy

• Theoretically, relativeness of monetary policy in comparison with fiscal policy is discussed by examining Keynesian and monetarist view on the subject.

• Practically, various limitations or the factors disturbing the effectiveness of monetary policy in the real world are discussed.

The IS curves slopes downwards because as income increases, saving also increases and rate of interest

falls

• Each point on the IS curve is a point of equilibrium between saving and investment, indicating equilibrium in the product market

• IS curve is derived from the goods market which shows the equilibrium

of Aggregate Supply and Aggregate Demand

The LM curve slopes upwards because as income increases, rate of interest also rises because of a rise in the demand for money. LM curve is derived from the money market.Each point on the LM curve is a point of equilibrium in the money market.

• The intersection of the IS-LM curves determines the equilibrium levels of income and rate of interest.

• Effectiveness of monetary policy is a function of the slopes of the IS and LM curves

• The flatter the IS curves (i.e. more interest elastic the investment)

• And/or the steeper the LM curve (i.e. lesser the speculative demand for idle money and greater the tendency to spend)

• And more effective will be the monetary policy.

• Keynesians are the followers of J.M Keynes.• They have reformulated his original ideas

• The capitalists economy is inherently unstable

• The instability is primarily due to the variability of investment sending and produces violent business cycles

• Such an economy needs to be stabilized can be stabilized by appropriate monetary and fiscal policies.

• Keynesians believe that the economy operates under liquidity trap range (horizontal LM curve)

• Only fiscal policy can influence the macro economic variables

• The IS curve is considered to be vertical or inelastic

• General economic condition of economy resembles that of depression; prices, income level, rate of interest and velocity of money are very low and speculative demand for money is very high.

• Keynesians believe that fiscal policy is superior and more effective than monetary policy.

Fiscal policy is more effective because it affects aggregate demand:

• Directly through changes in the government expenditure, and

• Indirectly through changes in tax and transfer payments which cause changes in consumption.

Monetary policy is less reliable because: a) Monetary policy is less predictive in its

results. • During depression, people have a tendency

to build money rather than purchase bonds.

• Thus according to the equation of exchange:

MV = PT = Y1

• The net change in MV, and hence in PT equals Y, is unpredictable.

b) Monetary policy will be effective if:

• Increase in money supply leads to significant fall in interest rate

• Fall in interest rate leads to significant increase in investment.

Symbolically: ΔM → Δi → ΔI → ΔAD

• But in depression, interest rates are already low and Demand for business loans is very small

• Thus both the links, i.e. ΔM → Δi and Δi → ΔI are weak

• Monetary policy will be ineffective during depression.

c) In the short run, the price level and the level of nominal national product are determined by a number of factors like:

• fiscal policy, • changes in autonomous consumption,

inflationary expectations • and shifts in aggregate supply

d) During inflation, Monetary authority can decrease the supply of money and cause interest rates to rise. Financial institutions can be forced to meet reserve requirements.

• But, here also Keynesians are doubtful about the efficacy of monetary policy because of its effects on velocity of money.

• When money supply is increased, velocity of money falls and when it is decreased, velocity increases.

• The capitalist economy is inherently stable• That much of the instability actually experienced

since World War 2 has been the result of active fiscal and monetary policies

• That there is no need to stabilize the economy• That if there is need, it cannot be done because

stabilization policies are more likely to increase than to decrease instability.

• Economy operates under the classical range (vertical LM curve), so that only monetary policy (i.e. changes in the LM curve) can affect the level of income, output and employment.

• Fiscal policy in not considered to be very effective in affecting the macro variables. It is maintained that, other things being constant, changes in government expenditure can cause multiplier effects.

• However, other factors (e.g., the rate of interest) are not likely to remain constant. If government expenditures are financed by borrowing from the public, interest rates will inevitably rise and some private institutions will be crowded out.

• Monetary policy is believed to be more effective in influencing macro economic variables especially in the period of depression.

• While the monetarists prefer monetary policy, their true position is that the discretionary monetary policy may have destabilizing effects on the economy.

• Therefore, monetarists prefer a monetary rule that reflects the economy’s growth rate of output.

• When the IS curve (IS1) cuts the LM curve in the Keynesian liquidity trap range:

• When the IS curve (IS2)

cuts the LM curve in the Keynesian range• An increase in the money supply (from LM0 to LM1)

is completely in-effective

• Speculative demand for money is maximum

• Velocity of money is minimum• Rate of interest remains unchanged at

the lowest level O1

• Investment is not encouraged• There is no increase in the income level

• When the IS curve (IS3) cuts the LM curve in the classical range:

• An increase in the money supply (LM0 to LM1) is most effective

• Speculative demand for money is zero• Velocity of money is maximum

• interest rate falls from (OI2 to OI1)

• investment increases

• … as a result income increases 

• When the IS curve (IS3) cuts the LM curve in the intermediate range:

• An increase in money supply will increase thelevel of income but not as much as in the classical range whenthe LM curve is vertical.

• In the classical case the rate of interest falls so much as to absorb the additional money supply into the transactions demand

• Leads to the increase in investment.• In the intermediate range, a part of the increase in

money supply will be held for speculative motive.• As a result investment will not increase to the

extent as in the classical case and income will increase by a lesser amount (from OY1 to OY4)

• An increase in money supply from (LM2 to LM1) is completely ineffective when investment is completely interest inelastic (i.e. horizontal IS4) income increase (from OY1 to OY5)

• An increase in money supply (LM2 to LM1) is completely ineffective when investment is completely interest inelastic (i.e. vertical IS5) income does not increase at all and remains at OY1 level.

• An increase in money supply (from LM2 to LM1) is more effective when investment is relatively elastic (flatter IS) income increases from OY1 to OY4

• An increases in money supply (from LM2 TO LM1) is less effective when investment is relatively inelastic (i.e. steeper IS) income increases from OY1 to OY3

• The extreme Keynesian and monetarist views are partial, one-sided and contain half truths. Both the approaches deal with a particular phase of trade cycle in a capitalist economy.

• Keynesian view is more suitable during the phase of depression; it is useful in forecasting changes in income level when the economy is experiencing depression.

• Monetarist view works in the inflationary phase; it helps in forecasting change in income level in an inflationary situation.

• The Moderate View is that more of monetarism and less of Keynesianism during inflation and more of Keynesianism and less monetarism during deflation. It will help in promoting economic growth with stability in developed countries.

• However, all the three approaches (i.e., extreme Keynesian, extreme monetarist and the moderate approaches) will not be of much help to the developing economies because these approaches mainly deal with the regulation of demand and supply of monetary factors, whereas the developing countries are facing the real problem of generation and allocation of physical factors.