Question

4.

a. Use the IS-LM-PC model to illustrate an economy experiencing zero lower bound and operating below the natural rate of output.

b. Explain and illustrate why expansionary monetary policy may not help to raise the output level to the natural rate.

c. Offer two alternative policies that would work to reduce unemployment under these circumstances. Explain and illustrate your answers.

Answer 1

a. Liquidity trap is the case where people don't want to keep their money in banks after the interest rate drops at a certain sum. Though the rate is so low, people want money to keep on their own. In this situation interest rate equal to zero or nest to zero, they sense an advertisement impact from the economy or any other uncertainty.

The diagram shows the initial interest rate is P2 and the sum is Q2 but when the interest rate falls between P2 and Pl and the bank's demand decreases from Q2 to Q1 as well.

Model es clearly states that the investment decision is taken by the investor, with the amount of money and interest that is available.

b. The expansionary policy should not raise interest rates as the people fear negative effects such as recession and war or any other potential uncertainty.

c. The alternative solution is first to increase the interest rate that will offer confidentiality to investors. Second, to boost the economy, government expenditure needs to be increased.