Question

Which of the following statements is NOT correct under the IS-LM (Fixed Price) model?

• A. The LM curve represents the combinations of income and interest rate, where money market is in equilibrium.
• B. The IS curve represents the combinations of income and interest rate, where product market (goods and services) is in equilibrium.
• C. An increase in money supply raises income and reduces interest rate when the IS curve has negative slope and the LM curve has positive slope.
• D. Monetary policy has a relatively weak effect on income when the interest responsiveness of the demand for money is relatively low.

Answer 1

The Correct Option is D

The IS-LM model, part of macroeconomic theory, explains the relationship between the interest rate (i), income (Y), goods market (IS curve), and money market (LM curve) under assumptions like fixed price level. The objective is to determine the equilibrium of economy when the product and money markets are in balance.

1. The LM curve represents all combinations of income and interest rate where the money market is in equilibrium. It slopes upwards because higher income leads to increased demand for money, thereby increasing interest rates if money supply is constant.
2. The IS curve represents combinations of income and interest rate where the goods market is in equilibrium. It slopes downwards, indicating that higher interest rates decrease investment, thereby lowering aggregate demand and output.
3. Monetary Policy and LM Curve: An increase in money supply shifts the LM curve downwards or to the right, which typically decreases interest rates and increases income. This effect is more pronounced if demand for money is responsive to interest changes (or highly elastic).
4. The incorrect statement, given the above explanations, is: "Monetary policy has a relatively weak effect on income when the interest responsiveness of the demand for money is relatively low." This contradicts the usual model interpretation because low interest responsiveness actually means that the LM curve is steep. This condition would lessen the typical effects of a monetary policy shift as changes in money supply would not significantly lower interest rates or affect income.

Therefore, the correct answer is that the statement regarding the weakness of monetary policy on income, due to low interest responsiveness of money demand, is FALSE. In reality, this makes monetary policies less effective.