Question

1. Under which set of conditions is fiscal policy most effective?

a vertical LM curve

a steep IS curve and relatively flat LM curve

a relatively flat IS curve and steep LM curve

2.

For Keynes the opportunity cost of holding money is?

		the interest rate earned on bonds
		the commodities one could have purchased
		the liquidity associated with money
		the equity that could have been earned in stocks

3.

In terms of the speculative demand for money, how would abnormal and extremely low interest rates be viewed by agents?

		agents would expect the interest rate to rise in the future, providing a capital gain on bonds, agents hold less money and more bonds
		agents would expect the interest rate to rise in the future, providing a capital lose on bonds, agents hold more money and fewer bonds
		agents view low interest rates as a great time to refinance their home
		agents use low interest rates to borrow more money investing abroad at higher rates

steep IS and LM curves

Answer 1

1. The correct answer is steep IS and relatively flat LM curve. When this is the case, the expansionary fiscal policy will have the least crowding out effect due to flat LM and the rise in income will be relatively more as compared to other cases.

2. The correct answer is the interest earned on bonds. Keynes believed that when an individual will prefer liquidity or hold money, he will not be able to invest this money in bonds and he will lose out on the interest which he can earn by investing in bonds.

3. The correct answer is that agents would expect the interest rate to rise in the future, providing a capital lose on bonds, agents hold more money and fewer bonds.

This is because when interest rates are extremely low, it becomes a situation of liquidity trap. In this case, agents expect that the interest rates will rise in the future. Due to this, they will avoid bonds and keep their savings in cash in order to earn more in the future when interest rates increase. Also, because interest rates are inversely related to bond prices, many consumers do not want to hold the asset whose price is expected to decline in the future.