Inelastic Demand and Fiscal Policy

When the rate of money demand becomes inelastic, it signifies that a buyer’s demand for a product does not change in proportion to the change of the product’s price. For instance, in a situation in which the price increases by a rate of 20% while demand decreases by the rate of only %1, the demand can be said to be inelastic. This situation is often encountered in the market of everyday household products or services. Prices can increase but consumers will continue to purchase similar amounts of goods as before the price change, as their needs for the products remain the same.

The example on slide 5 refers to government spending in relation to implementing efficient fiscal policy actions. The increase in government spending will influence an increase in output and money demand. This will likely cause firms to struggle with finding funds in order to maintain the increases in output. However, this may also lead them to increasing interest rates due to the inelasticity of demands. Because demands are limited, increased interest rates should compensate for the lack of funds. Such a procedure has a negative effect on investments, as investors will be discouraged by the high interest rates.

Fiscal expansions in 2001 had substantial effects on shifts in the IS or LM curve (Li, 2019). The increased net government spending caused a rightward shift of the IS curve, which indicated higher output. Additionally, the fiscal policies avoided the shifts of the IS curve due to high interest rates, and in turn, avoided the shifts in the AS curve which would have led to a downward cycle of economic welfare. These changes altered the economy by reducing the duration and extension of the recession that followed the tech-bubble burst.

Reference

Li, Y. (2019). This is now the longest US economic expansion in history. CNBC. Web.