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a. Why does a horizontal LM curve imply that fiscal policy has the same effects on the economy as those derived in the Keynesian Model (horizontal AS)?

b. What are the implications of a horizontal LM curve for the link between the goods market and asset market?

c. Under what circumstances might the LM curve be horizontal?

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Divya Singh
Divya SinghLv10
28 Sep 2019

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Related questions

Short answer: Answer each of the questions in Section B. Answers should typically be no more than 2-3 sentences in length.

1. In the Mundell-Fleming model, what are the two endogenous variables that appear in the goods-market equilibrium condition (after substituting in all relevant functions, e.g., C = C(Y ? T), etc.)? How does this compare to the case in the (closed economy) IS-LM model? Be sure to explain the reason for any differences

2. Briefly describe how “debt deflation” works; that is, how this mechanism might cause an unexpected fall in the price level to produce a large fall in output (e.g., in the Great Depression).

3. Consider the IS-LM model, and suppose G increases by ?G units. In general equilibrium, does output increase by more, less, or the same amount as µG × ?G (where µG is the government spending multiplier)? Be sure to explain why this is the answer.

11. Statement 1: The multiplier for autonomous consumption, I and G are different given a specific value of MPC.

Statement 2: The lumpsum tax multiplier is always the G multiplier times the MPC.

a)Statement 1 is true, Statement 2 is true.

b)Statement 1 is true, Statement 2 is false.

c)Statement 1 is false, Statement 2 is true.

d)Statement 1 is false, Statement 2 is false.

12. Pick the correct statement

a)Every point on the IS curve corresponds to an equilibrium value of Y, for a given value of r.

b)Every point on the IS curve corresponds to an equilibrium in the commodity market.

c)Both (a) and (b)

d)None of the above

13. Increase in real money supply

a)Shifts the IS curve to the right

b)Shifts the LM curve to the right

c)Both (a) and (b)

d)None of the above

14. Together the IS-LM model shows an equilibrium. This equilibrium denotes

a)An equilibrium in the commodity market

b)An equilibrium in the money market

c)An equilibrium in the market for loanable funds

d)All of the above

15. Suppose that an expansionary fiscal policy has been enacted. To keep interest rates unchanged, what must the central bank do?

a)Nothing

b)Lower real money supply

c)Raise real money supply

d)None of the above

1. Why Niall Ferguson thought that the expansionary fiscal policy (or government deficit) could produce crowding-out effect? You can explain by using the IS-LM model or you can use the logic of loanable funds theory

Answer: Ferguson believes that an increase in the government deficit could produce a crowding-out-effect. First, I will touch base on fiscal policy. Well, what is it? Basically, it adjusts the nation’s spending amount which increases the economy’s deficit to close a recessionary gap, which therefore increases the the demand for loans, meaning people want to borrow money. An increase in demand for loans leads to an increase in interest rates. Higher interest rates lead to a decrease in investment and interest-sensitive consumer spending, so both C and I decrease. That’s what the crowding-out-effect is, the decrease in investment due to higher interest rates.

>in Deficit = >in Demand for Loans = >in interest rates =

The government speeds up the economy by deficit spending, they crowd out consumers and investors with high interest rates. So what this means is that the government is attempting to help the economy but it is actually hurting the economy. The reason why I think Ferguson believes this is because of what he says in his debate at the New York Review of Books, that “you can’t be both a monetarist and a Keynesian simultaneously—at least I can’t see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.” He continues on in the interview to say that the Fed has minted out a fresh $1.75 billion in bonds and that no one is going to buy them. Driving up bonds will increase interest rates which increases mortgage rates which is why he basically doesn’t agree with the Keynesian theory.

2. Why Paul Krugman thinks that Niall Ferguson was wrong and thought that government deficit could not produce a crowding-out effect? In other words, please explain Krugman's Liquidity trap .

Answer: To start I think Krugman believes that the Fiscal policy is effective. It is effective when the Liquidity-Money (LM) curve is horizontal. It creates the crowding in effect. The supply of money is constant so it creates money demanded to be interest inelastic, meaning it doesn’t change. So if the government wishes to stimulate the economy, it leaves interest rates at a constant rate, and an increase in investment and saving, therefore helping the economy close the gap on a recession. There is an indifference between money and bonds so this makes fiscal policy effective. So then we get into a monetary expansion, meaning we have an increase in the money supply. Well with the liquidity trap, we get the case that the investment-savings (IS) curve is horizontal. So when the government increases the money supply, investment responds to rapidly changing interest rates, which would decrease the money demanded, making monetary policy effective. But the liquidity trap becomes apparent because interest rates cannot fall below zero percent. This is when monetary policy would become ineffective because interest rates aren’t declining meaning investment wouldn’t continue. Krugman in his blog basically argues this. He states “Most spectacularly, IS-LM turns out to be very useful for thinking about extreme conditions like the present, in which private demand has fallen so far that the economy remains depressed even at a zero interest rate.” He sums up his argument for the liquidity trap and explains his logic behind the investment-savings, liquidity-money curve, and that is why he disagrees with Ferguson.

3. In the discussion, other discussants such as George Soros and Robin Wells pointed out some interesting issues. Please provide at least one thing that you agree and one thing that you disagree. Discuss in details why you think so.

Answer: One thing I found interesting was George Soro’s point in the debate in the New York review of books. He states “The other feature is that the financial system collapsed of its own weight. That contradicted the prevailing view about financial markets, namely that they tend toward equilibrium, and that equilibrium is disturbed by extraneous forces, outside shocks. Those disturbances were supposed to occur in a random fashion. Markets were seen basically as self-correcting. That paradigm has proven to be false. So we are dealing not only with the collapse of a financial system, but also with the collapse of a worldview.” He continues to mention how Obama has 2 problems he has to face and how people who are viewing this crisis the same as the previous financial crisis, are making a huge mistake. To explain he states this: “But when you have a collapse of credit there’s only one source of credit that is still credible, and that’s the state: the Federal Reserve and the Treasury. Then you have actually to inject a lot more leverage and money into the economy; you have to print money as fast as you can, expand the balance sheet of the Federal Reserve, increase the national debt. And that is, in fact, what has been done, which is the right thing to do. But then once this policy is successful, you have to rein in the money supply as fast as you can.” I think Soro is agreeing with Krugman and the monetary policy of pumping money into the economy. It will raise the money supply which eventually is left for us to capitalize on supply and let our GDP. Now I find this interesting because he is also agreeing with Krugman’s IS-LM model, and later on, we come to find out that even Ferguson had come to an agreement with Krugman’s points, with the exception being that the United States was a powerhouse, and therefore the European Union would eventually see its downfall.

Please make comments to the answer of discussion I provided above(at least 300 words total). And you can start with "I agree with you on some points... But I disagree with you on some points".

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