Question

Considering the transmission mechanism for stimulative fiscal policy, explain why it is advantageous for the effectiveness of fiscal policy if the interest elasticity of investment demand has the value the Keynesians say it does. Explain the transmission mechanism through to its effect on GDP, and explain why the (Keynesian) interest elasticity of investment demand is important in the transmission mechanism. (Do not include any illustrations for this question.)

Answer 1

Transmission mechanism for fiscal policy explains how a fiscal policy will impact gdp i.e. how goverment decisions to increase or decrease taxes will impact demand in the economy and how that will impact the GDP.

stimulative fiscal policies aims to increase demand in the economy

Interest elasticity of investment is simply the responsiveness of investment to changes in the interest rate i.e. by how much amount investment will change when there is a given amount of change in the interest rate.

Keynes says that the interest elasticity of investment is high.

This is advantageous for effectiveness of fiscal policy because if the policy aims to boost gdp and interest elasticity of investment is high, this implies that even a small rise in goverment expenditure will raise investment in economy

so if people are not initially investing in bonds due to low interest rate as in situation of a liquidity trap. A small push by goverment will have big impact on investment and thus on GDP.

the transmission mechanism goes like this

Goverment raise expenditure as a stimulative fiscal policy

This increases income in Economy

Interest rate increases as money demand curve shifts up

So people start investing

Which will have a multiplier effect and raise GDP and demand in Economy

Interest rate elasticity is important for transmission mechanism as it will decide how much investment will respond to changes in interest rate due to fiscal or monetary policy and thus will decide the multiplier effect of change in investment on GDP.