Question

Why is fiscal policy more effective in the Keynesian model when interest rates are at 0? Show this graphically with the money market graph.

Answer 1

Ans. When interest rate is zero then the money demand function, L, depends entirely on output (Y) and not on the interest rate (i). This means that people are willing to hold any amount of money at given interest rates. This makes the LM curve  the x-axis in the region of zero interest rate. Now, any shift in IS curve increases the output by full value. Intuitively, a zero interest rate will make it easier fir the investors and households to take loans and inncrease investment and consumption respectively, so, increasing the government expenditure or fiscal expansion will lead to shift of IS curve by multiplier times the increase in expenditure but as interest rates remain zero, so, crowding out won’t happen and equilibrium output would also increase by multiplier (m) times increase in government expenditure (G). As shown in the diagram an increase in government expenditure by G leads to a rightward shift of IS curve to IS’ leading to an increase in equilibrium income by m*G.

It is also important here that the monetary expansion won’t work in this scenario as the main point of monetary expansion is to boost the economy by lowering the interest rates so that people consume more rather than saving and investments increase but already zero interest rate serve the purpose and if interest rates fall further people won’t save money in banks and this will not lead to increase in liquidity and lending power of banks.

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