Question

Under conditions of a liquidity trap and interest-insensitive investment, keynesians would be most likely to propose __________ policy to eliminate a recessionary gap.

Answer 1

To combat a recessionary gap during a liquidity trap with interest-insensitive investment, Keynesians suggest expansionary fiscal policy, using tax cuts or increased government spending to boost aggregate demand and achieve full employment.

Step-by-step explanation:

In conditions of a liquidity trap where monetary policy is ineffective and investment is not responsive to changes in interest rate, Keynesians would most likely propose expansionary fiscal policy to eliminate a recessionary gap. This approach involves using tools such as tax cuts to stimulate consumption and investment, or direct increases in government spending, both of which serve to shift the aggregate demand curve to the right. For example, if the aggregate demand is too low, leading to a recessionary gap, the expansionary fiscal policy would aim to increase aggregate demand from its current level (ADr) to a higher level (ADf) where the economy operates at potential GDP and full employment.

Answer 2

Under conditions of a liquidity trap and interest-insensitive investment, Keynesians would be most likely to propose expansionary monetary policy to eliminate a recessionary gap. The reason is because they believe that prices and wages are inflexible downward but not upward and that it is more likely that natural forces will move an economy out of an inflationary gap than out of a recessionary gap.