Question

Why do you think the fiscal multiplier in countries where interest rates are close to zero are bigger than in that in emerging countries? What is this special condition called? Explain using the IS-LM model.

Answer 1

The situation when the rate of interest is close to zero is explained by Keynes as "Liquidity Trap" where at a given rate of interest people are willing to hold any amount of money. In this situation, LM curve is horizontal and monetary policy is ineffective in changing the rate of interest. Also, fiscal expansion, in this case, would shift IS curve to the right, with a fixed rate of interest there is no crowding out effect and the output will increase by full multiplier effect of an increase in government spending or reduction in taxes.