Question

Tom noted that “The Federal Reserve is doing everything it can to keep the Turkey 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

In India

Fiscal Policy : Fiscal policy refers to that segment of national economic policy which is primarily concerned with the receipts and expenditure of central government. These policies affect tax rates, interest rates and government spending, in an effort to control the economy

The effects of Fiscal Policy

a. Taxation: Through effective fiscal policies, the government aims to mobilise resources by way of direct taxes as well as indirect taxes because most important source of resource mobilisation in India is taxation.

b. Public Savings: The resources can be mobilised through public savings by reducing government expenditure and increasing surpluses of public sector enterprises.

c. Private Savings: Through effective fiscal measures such as tax benefits, the government can raise resources from private sector and households. Resources can be mobilised through government borrowings by ways of treasury bills, issuance of government bonds, etc., loans from domestic and foreign parties and by deficit financing.

d. Reduction in inequalities of Income and Wealth: Fiscal policy aims at achieving equity or social justice by reducing income inequalities among different sections of the society. The direct taxes such as income tax are charged more on the rich people as compared to lower income groups. Indirect taxes are also more in the case of semi-luxury and luxury items which are mostly consumed by the upper middle class and the upper class.

In America

Fiscal policy is the application of taxation and government spending to influence economic performance.

Effect of Fiscal policy

The most immediate effect of fiscal policy is to change the aggregate demand for goods and services. In an open economy, fiscal policy also affects the exchange rate and the trade balance. In the case of policy expansion, the rise in interest rates due to government borrowing attracts foreign capital.

The main aim of adopting fiscal policy instruments is to promote sustainable growth in the economy and reduce the poverty levels within the community. In the past, fiscal policy instruments were used solve the economic crisis such as the great recession and during the financial crisis.

They are effective in jump-starting growth, supporting the financial systems, and mitigating the economic crisis on the vulnerable groups especially the low-income earners and the poor. The most commonly applied fiscal policy instruments are government spending and taxes. The government increases or reduces its budget allocation on public expenditure to ensure vital goods and services are provided to the citizens.