Question

Explain two possible failure of monetary policy in Keynesian Transmission mechanism in terms of liquidity trap and vertical investment schedule

Answer 1

The objective of the monetary policy is to regulate the money supply, spending patterns in the economy and affect the formation of aggregate demand. It is done via change in money supply and interest rate. But on occasions, the monetary policy becomes ineffective. The first ineffectiveness comes when there is an occurrence of liquidity trap. It happens when lowering interest rate does not encourage the spending and aggregate demand is not affected. The purpose of lowering interest rate is that lower interest rate level will attract households and firms to spend. But, it will not happen as there will be less demand and households will focus more about savings. So, liquidity trap will takes place and monetary policy fails.

The second failure takes place when there is a presence of vertical investment schedule. Here, the investment spending is non-responsive to the interest rates. So, change in interest rate, does not change the investment pattern. So, monetary policy fails to achieve the objective. A rationale behind is that investment spending is a long term planning and it does not change with the short term changes in the interest rates.