Consider two economies, one facing a liquidity trap (a horizontal LM curve) and the other does...

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. at least 100-200 words please

Solutions

Expert Solution

Economy in liquidity trap (horizontal LM curve)

Here, any monetary policy will not work.

Fiscal policy will be highly effective.

Fiscal policy will shift the IS curve, and real GDP will be adjusted accordingly.

Any change in fiscal policy will leave interest rates unaffected.

Here, IS" is expansionary fiscal policy, and IS is contractionary (with respect to IS'). They change the real GDP accordingly, without affecting interest rates.

Economy with upward sloping LM curve

Here, monetary policy will work, if applied.

Fiscal policy will be effective.

Fiscal policy will shift the IS curve, and real GDP will be adjusted accordingly.

Any change in fiscal policy will change interest rates.

Here, IS" is expansionary fiscal policy, and IS is contractionary (with respect to IS').

They change the real GDP accordingly, but interest rates also change.

Due to change in interest rates, Aggregate Demand may get affected. This causes fiscal policy to be slightly less effective.

Rahul Sunny answered 1 year ago

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