Question

Consider an economy with zero interest rate and aggregate output less than its natural output (liquidity trap).

b. What type of fiscal policy is needed to reduce unemployment rate and increase output? Show on the graphs.

c. Do you think that the policy packages in response to the 2008 financial crisis (great recession) were effective? If so, why the recovery took long?

Answer 1

Ans.

b) liquidity trap is When despite zero interest rate people want to hold cash than spend. Monetary policy becomes ineffective as an increase in money supply fails to increase spending because interest rate cannot fall more further. So there is need of fiscal policy in such economy to reduce unemployment rate and increase output. The expansionary fiscal policy helps in reducing unemployment rate i.e by cutting taxes or increase government spending. It will lead to higher aggregate demand and thus increasing output. According to following IS-LM curves increase in government spending or tax cuts shifts IS to the right causing income to increase where LM curve is horizontal as there is no change in interest rate. The diagram is as follows:

C) During global financial crises in 2008 expansionary fiscal policy was effective. During that period many developed countries such as Japan, Europe were in liquidity trap . The short term interest rates for central bank were close to zero. Moreover rise in monetary base did not effect interest rates or commodity prices. So expansionary fiscal policy was effective that is government increase its spending. The recovery took longer time period as there was high unemployment rate and lower aggregate demand. Aggregate demand can be increased by public spending but following the recession in 2009 it was slow compared to other business cycles.