Question

Read the following text and please answer.

“The Bangladesh Bank has created additional money worth Tk70,794 crore through various refinance
schemes and easing regulatory requirements after the Covid-19 outbreak in March for stimulating
demand to revive the declining economy.
.

Question: According to Keynesians, how can the transmission mechanism get blocked? Given the current
Covid-19 situation, do you think these two issues occurring are likely? Explain your answer
linking the two issues to the current situation. Use diagrams.

Answer 1

Easy credit policies have been adopted by many countries to cone out of the economic crisis and restart their industries. However, such policies form part of Monetary Policy framework and economists have varying degrees of success perceptions regarding such policies. Keynesians are more inclined towards kickstarting the economy via fiscal measures such as raising government expenditure.

According to them, monetary policies may get caught up in ineffective transmission due to two reasons:

• Liquidity Trap: It is a situation in which public is prepared to hold the entire amount of money as cash. This arises at very low interest rates. In such cases, LM curve is horizontal and change in money quantity will not shift the LM curve. When that happens, monetary policy does nothing to change interest rates or level of income.
• This happens because at low interest rates people will not want to hold bonds as prices of such bonds are high. In addition, at such low interest rates their money is not earning any income and they prefer to hold raw cash to meet transaction demands. Therefore, monetary policy will be ineffective as the first step of transmission is not operating.

• Investment is insensitive. Monetary policy will be ineffective in changing output or income if IS curve is vertical. This happens when interest elasticity of investment is zero I.e. investment is unresponsive to change in interest rate. In such situations, step 2 of transmission mechanism will my operate.

These cases are very likely in the given situations. There is already lack of incentives to invest and thus a low of Investible surplus is lying in the economy. This means that interest rates are not really a factor that is stopping the investors from investing. Moreover, businesses have excess capacity because of which they aren't looking for funds, rather they are seeking demand growth to use their full capacity. In such situation, increasing money supply will only mean tanking interest rates to a level of liquidity trap.

Thanks!