Question

Recently TOM noted that “The Federal Reserve is doing everything it can to keep the Germany. economy from crashing during the shutdown to fight the Covid-19 pandemic. But some people fear that the Fed has fallen into a ‘liquidity trap.’”Liquidity trap refers to a situation in which an increase in the money supply does not result in a fall in the interest rate: the interest elasticity of demand for money becomes infinite. Under normal conditions an increase in money supply, resulting in excess cash balances, would cause an increase in bond prices, as individuals sought to acquire assets in exchange for money, and a corresponding fall in interest rates.In such a situation, described by Keynes as liquidity trap, individuals believe that bond prices are too high and will therefore fall, and correspondingly that interest rates are too low and must rise. They, therefore, believe that to buy bonds would be to incur a capital loss and as a result they hold only money. This means that an increase in the money supply merely increases idle balances and leaves the interest rate unaffected.

If low interest rates can’t stimulate people to spend enough to keep the workforce at full employment, the risk is that a liquidity trap will set off a deflationary spiral in which prices fall, causing people to delay spending, which makes prices fall even more, and so on.

Consider two economies, one facing a liquidity trap (a horizontal LM curve) and the other does not (upward sloping LM curve). Discuss the effects of fiscal policy in these two different countries.

Answer 1

Where C = consumption function

I = investment function

G = government expenditure

Government multiplier means that if government expenditure increases by 1 unit, the output will increase by 1/1-c(1-t) times.

Economy A : effectiveness of fiscal policy in case of upward sloping LM curve

This country is depicted in figure 1. If the economy employs fiscal policy, say by increasing government expenditure then the increase in government expenditure results in reducing private investment. This process is called crowding out. An increase in government expenditure (which shifts IS curve from IS1 to IS2), financed by borrowings from the market will result in reducing liquidity. This will increase the cost of borrowing and interest rate in the market. There will be excess supply of bonds due to which bond price fall and interest rate rises. AS interest rate increase, private investment falls and so does output. Therefore, output does not grow by the entire amount. In figure 1, after the government increases expenditure, the increase in output should have been EB but the interest rate rises from r1 to r2, thereby the actual increase in output is just EA. Thus fiscal policy is partially effective.

Figure 1

Economy B : effectiveness of fiscal policy in case of liquidity trap- horizontal LM curve

Liquidity trap arises when Interest sensitivity od money demand becomes infinite. LM curve is horizontal because people do not transact in bond market under the assumption that bond price is highest and interest rate is lowest possible. According to Keynesian theory, any fiscal expansion in case of liquidity trap will increase the income by the entire amount of shift of IS because there will be no crowding out. An increase in government expenditure will increase income but no one will go to bond market resulting in no change in Interest rate and therefore, fiscal policy is fully effective in case of liquidity trap. As seen in figure 2, when IS shifts due to fiscal policy, the shift in IS curve is entirely equivalent to shift in income from Y1 to Y2. Therefore, in this case, fiscal policy is fully effective.

Figure 2