The paper "Fiscal Policy in a Liquidity Trap" is an outstanding example of a micro and macroeconomic assignment. Fiscal policy is the government’ s attempt to influence aggregate demand in the economy by regulating the amount of public expenditure and the rates of taxation. This policy is made more flexible by the fact that governments do not need to keep ‘ balanced budgets’ -they can run a budget surplus by spending less than they raise in taxes. Under normal circumstances change in government spending causes income to rise and this, in turn, causes the transactions to demand money to increase; with a constant money stock, less is now available for speculative purposes, so that interest rates are pushed upwards and this causes private investment to be cut back, so offsetting to some extent the effect of the increase in government spending on income. However, it is possible for fiscal policy to be completely ineffective so far as its influence over equilibrium national income is concerned.
This when the level of income remains unchanged whichever fiscal policy is applied. This is a point of the liquidity trap.
In a liquidity trap, interest rates are unaffected by fiscal policy, but income rises by the full multiplier effect. Figure 1: Fiscal policy completely ineffective figure 2: Fiscal policy very effective From the two graphs above, the effectiveness of fiscal policy is shown by the steepness of the IS curve. The policy would be completely ineffective if the IS curve were horizontal but would have its full effect if it were vertical. The steepness of the IS curve depends largely on the interest-elasticity of investment completely interest-elastic investment yields a horizontal IS a curve, as shown in figure 1; increased government expenditure leaves the IS curve unchanged so that the policy has no effect on income.
The perfectly interest-inelastic investment would yield a vertical IS a curve, as shown in figure 2 and, in this case, an increase in government expenditure would have a full multiplier effect.
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