Question

The keynesian argument against the effectiveness of monetary policy in stabilizing income is based on the hypothesis that investment spending is not very responsive to changes in interest rates. Suppose that monetary policy does affect interest rates. Why (in the keynesian model) would this mean that monetary policy has little effect on spending and income? Answer: because the keynesian story goes like this. Expansionary monetary policy causes 1.)________ to fall. This would lead to an increase in 2.)_______ and that would, in turn, cause spending/income to rise. However, if 1.) has only a 3.)_______ on 2.) this would mean that expansionary monetary policy would not lead to significant increases in spending/income.

Answer 1

1) Interest to fall.

2) investment

3) If interest has only a limited effect on investment this would mean that expansionary monetary policy would not lead to significant increase in spending.

As per the Keynesian school of thought, an increase in the money supply will cause the interest rates to fall. which increases the marginal efficiency of capital allowing the people to invest more. But, if the business sentiments are low then any decrease in the interest rate will not have much effect on the investment. This will result in less demand increase and recession prevails.