Question

1. Why did Keynes prefer Fiscal Policy to Monetary Theory?
   • How can they work together?
   • What is the Liquidity Trap for Keynes?  Does it apply to the economy today?

Answer 1

Keynes prefer Fiscal Policy to Monetary Theory because Keynes believed that economy can be out of recession onlywith autonomous investment by government to increase aggregate demand and individuals should save less and spend more, raising their marginal propensity to consume to effect full employment and economic growth. In this theory, one dollar spent in fiscal stimulus eventually creates more than one dollar in growth.

In response to this, Keynes advocated a countercyclical fiscal policy in which, during periods of economic woe, the government should undertake deficit spending to make up for the decline in investment and boost consumer spending in order to stabilize aggregate demand

Liquidity trap- First described by economist John Maynard Keynes, during a liquidity trap, consumers choose to avoid bonds and keep their funds in cash savings because of the prevailing belief that interest rates could soon rise (which would push bond prices down).

Not only high inflation, but low inflation can be bad for the economy. ... Therefore, the correct monetary policy during a liquidity trap is not to further increase money supply or reduce the interest rate but to raise inflation expectations by raising the nominal interest rate.