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My understanding is that in a functioning economy, the financial market clears when the nominal interest rate is above zero. It is only when it reaches zero that a liquidity trap occurs and the government must engage in deficit spending to borrow the money pooling in the financial market and make sure it is spent.

My question is this: Why would increased government deficit spending shift the AD curve when we are not in a liquidity trap situation? Every dollar that is spent by the government will have to be borrowed from somewhere - households. This would decrease their consumption by the exact same amount government spending increases.

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  • $\begingroup$ So for how long has the Swiss economy not been functioning? Or others with negative interest rates such as Germany? The zero lower bound turned out not to apply (to many people's surprise) and demand for their government bonds continued, as did their high employment rates $\endgroup$ – Henry May 16 at 20:43
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    $\begingroup$ The answer to this question is complex, and is going to depend upon economic school of thought. The argument that the money needs to be borrowed is “loanable funds,” which was rejected by Keynes. It only stands up in neoclassical theory if we assume Ricardian Equivalence. There is a long debate about Ricardian Equivalence. If we turn to post-Keynesian economics, the argument is rejected on the basis the assumptions behind Ricardian Equivalence are incorrect. $\endgroup$ – Brian Romanchuk May 16 at 21:48
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    $\begingroup$ Doesn't Ricardian Equivalence have to do with expectations of consumers about future taxes that they have to pay to finance the spending? I think my question is more oriented towards the fact that when the government borrows, it is directly borrowing from consumers and decreasing consumption by the exact same amount it is increasing government spending. $\endgroup$ – johnsmith13579 May 16 at 22:43

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