Question

a) Draw an ISLM model to show the state of the current US economy. The current short-term interest rate (fed funds rate) is low by historical standards, just under 2% (you do not need to list a numerical value of GDP on your graph).

b) Now draw the impact of a large decline in consumer spending that pushes the economy into a Liquidity Trap.

c) Explain the challenges facing The Fed if the economy is in a Liquidity Trap. Why is this a problem?

d) Explain one approach to alternative monetary policy that The Fed could try in a Liquidity Trap.

e) If the policy described in part D did not work, what Keynesian policy could be used to end the recession? Explain why this policy might work even when polices from The Fed do not work?

Answer 1

b) Decline in consumer spending decrease the aggregate demand, shifting the curve leftward to AD2. The new equilibrium is at B where the economy is stuck at a very low level of interest rate.

c) In liquidity trap, the people are highly interest sensitive. They are willing to hold as much money as possible at given rate of interest. The LM curve is horizontal and changes in the quantity of money does not shift it. So the monetary policy is completely ineffective.

d) The Fed could use an expansionary fiscal policy in this case. There will be no crowding out and the fiscal policy will be completely effective.