Question

11.22 An economy is in recession that is also in a liquidity trap. (a) Use an IS-LM-FE diagram to illustrate the economy’s situation. (b) Identify a policy that a Keynesian economist would recommend in this situation? (4 words MAX) (c) Identify a policy (of the policies discussed in this class) that a Keynesian economist would NOT recommend?  

Answer 1

a)A liquidity trap is a situation when the expansionary monetary policy is not able to increase interest rates and hence the economy does not grow. At this time the demand curve becomes elastic, the rate of interest is too low and cannot fall further. Money supply is held in form of cash balance and thus government is unable to use interest rates to stabilize economy.

A decrease in interest rates during such a scenario lead to shift in the IS curve and encourage spending but during the time of liquidity trap, change in money supply does not change the spending habits. as illustrated the LM curve doesn't impact. Thus, use of monetary policy is ineffective.

b) A Keynesian economist would suggest the government should intervene in crowd in resources left idle as fiscal policy can only improve things here. Government spending shall increase.

c)Government shall not indulge into any monetary policy as it is useless in such a scenario.

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