The effectiveness of monetary policy in changing output depends on the slope of the IS curve, which in turn depends on the responsiveness of investment and consumption to the real interest rate. The graph below shows two IS curves. Shows the case where households and firms do not increase consumption and investment much in response to lower interest rates; for households and firms are more responsive.

a. Show the effect on the output gap of a decrease in the target federal funds rate, given each of the IS curves.
b. How does the slope of the IS curve affect the ability of monetary policy to change real GDP?

Transcribed Image Text:

MP IS2 Y1 0 Output gap.y (percent deviation from potential GDP)