606 PA R T V I I Monetary Theory Monetary Policy Versus Fiscal Policy: The Cases of Complete Crowding Out The ISLM model developed so far in this chapter shows that both monetary and fiscal policy affect the level of aggregate output To understand when monetary policy is more effective than fiscal policy, we will examine a special case of the ISLM model in which money demand is unaffected by the interest rate (money demand is said to be interest-inelastic) so that monetary policy affects output but fiscal policy does not Consider the slope of the LM curve if the demand for money is unaffected by changes in the interest rate If point in panel (a) of Figure 23-7 is such that the quantity of money demanded equals the quantity of money supplied, then it is Interest Rate, i LM1 i2 i1 IS2 IS1 (a) Response to expansionary fiscal policy Y1 Aggregate Output, Y Interest Rate, i LM1 i1 LM2 i2 IS1 Y1 (b) Response to expansionary monetary policy Y2 Aggregate Output, Y FIGURE 23-7 Effectiveness of Monetary and Fiscal Policy When Money Demand Is Unaffected by the Interest Rate When the demand for money is unaffected by the interest rate, the LM curve is vertical In panel (a), an expansionary fiscal policy (increase in government spending or a cut in taxes) shifts the IS curve from IS1 to IS2 and leaves aggregate output unchanged at Y1 In panel (b), an increase in the money supply shifts the LM curve from LM1 to LM2 and raises aggregate output from Y1 to Y2 Therefore, monetary policy is effective, but fiscal policy is not