Question

36. Consider a depressed economy that, even after significant monetary stimulus efforts that pushed short-term interest rates to close to zero, still experiences a recessionary gap of 1,200 billion dollars and 10% unemployment rate. Economist estimate that the marginal propensity to consume is 0.75. Adress the following questions, briefly justifying all your answers. a) Would an increase in the money supply by the Fed help reduce the recession and the unemployment? Explain why or why not?

Answer 1

a. No, increase in the level of money supply by the Fed will not help to reduce the recession and the unemployment rate in the economy because the short term interest rates are close to zero which means that money demand curve is perfectly elastic at the rate of interest in the economy. This makes the money demand curve horizontal at the prevailing level of interest rate in the economy. Any increase in the money supply when the demand curve is horizontal will not lead to any change in the rate of interest in the economy and thus not impact investment level in the economy which in turn will not impact the level of aggregate demand in the economy. Thus, increase in money supply by the Fed in this case which is called as liquidity trap will not help to reduce recession and unemployment. This can be depicted as:

the There is no change in Rate of Interest Rate Md Interest E, I 1 M Mi ☆ Money