Model Answer
0 min readIntroduction
The IS-LM model, developed by John Hicks and Alvin Hansen, is a macroeconomic tool illustrating the interaction between the goods and money markets to determine equilibrium interest rates and output levels. It’s a cornerstone of Keynesian economics. A vertical IS curve implies that investment is unresponsive to changes in interest rates, while a vertical LM curve suggests that the money supply is infinitely elastic or that demand for money is infinitely sensitive to interest rate changes. When both curves are vertical, the economy faces a unique set of challenges regarding the effectiveness of both fiscal and monetary policies.
Understanding the IS and LM Curves
The IS curve represents the equilibrium in the goods market, showing combinations of interest rates and output levels where planned investment equals planned savings. The LM curve represents the equilibrium in the money market, showing combinations of interest rates and output levels where money demand equals money supply.
Vertical IS Curve: Fiscal Policy Ineffectiveness
A vertical IS curve indicates that output (Y) is fixed at its full employment level. This happens when aggregate supply is perfectly inelastic. In such a scenario, any attempt to increase aggregate demand through expansionary fiscal policy – such as increased government spending or tax cuts – will only lead to inflation. The increased demand simply bids up prices as the economy cannot produce more goods and services. Mathematically, this is represented by a zero multiplier effect. For example, if the economy is already at full capacity, a large infrastructure project funded by borrowing will not increase real output but will raise prices.
Vertical LM Curve: Monetary Policy Ineffectiveness
A vertical LM curve signifies that the money supply is perfectly inelastic, or that the demand for money is infinitely elastic with respect to the interest rate. This situation, often referred to as a liquidity trap, arises when interest rates are already near zero. Further increases in the money supply will not lower interest rates, and therefore, will not stimulate investment or consumption. People simply hoard the additional money, expecting interest rates to rise or prices to fall. Japan experienced a prolonged liquidity trap in the 1990s and early 2000s.
Combined Implications: Fiscal Dominance and Stagnation
When both the IS and LM curves are vertical, the economy is in a particularly difficult position. Monetary policy is rendered ineffective due to the liquidity trap, and fiscal policy is ineffective due to full employment. This leads to a situation of fiscal dominance, where fiscal policy becomes the only available tool, but its effectiveness is limited to influencing the price level. The economy is stuck at a fixed level of output, and any attempt to stimulate demand will only result in inflation. This scenario highlights the limitations of Keynesian policies in certain extreme circumstances.
Table Summarizing Implications
| Curve | Implication | Policy Effectiveness |
|---|---|---|
| Vertical IS | Full Employment, Fixed Output | Fiscal Policy: Ineffective (leads to inflation) |
| Vertical LM | Liquidity Trap, Zero Lower Bound | Monetary Policy: Ineffective (hoarding of money) |
| Both Vertical | Fiscal Dominance, Stagnation | Both Policies: Largely Ineffective |
Conclusion
In conclusion, the simultaneous presence of vertical IS and LM curves represents a challenging macroeconomic scenario characterized by the ineffectiveness of both fiscal and monetary policies. This situation, often associated with full employment and a liquidity trap, highlights the limitations of conventional demand-side policies and underscores the importance of supply-side reforms to boost potential output. Addressing such a situation requires a shift in focus towards structural changes that can increase the economy’s productive capacity and alleviate inflationary pressures.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.