So why did John Keynes believe that monetary policy to be less effective than fiscal policy for stabilising the level of economic activity, particularly in a recession?

Lowering markets' interest rate encourages borrowing and reduce the incentive to save, which to me it seems that it produces similar economic benefits to fiscal? But I guess that it takes time for the effects of low interest rate to flow through the transmission channels?

I suppose the reason why he favoured fiscal is tied to the time period he lived in?


This was due to the idea of liquidity trap, and due to Keynes thinking that in economic recession it is easy for an economy to slip into the liquidity trap. Liquidity trap is a situation where preference for holding cash becomes virtually infinite. Keynes (1936) in the 'General Theory' states:

There is the possibility...that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.

Infinite preference for holding money means that more savings will not necessary lead to more investment but rather reduced income (see Blanchard et al. Macroeconomics a European Perspective - box on the 'paradox of savings' on pp 55). Keynes called this the 'paradox of thrift' and in his own words (again quoting from the General Theory):

For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself.

Consequently, if an economy is in a liquidity trap monetary policy becomes impotent because monetary policy stimulates economy by lowering interest rate which encourages investment and borrowing and thus spending, as well as putting upward pressure on prices, which in turn helps to 'grease' the wheels of economy by reducing the frictions caused by sticky prices and wages (e.g. wages are very slow to adjust nominally so inflation can force real adjustment even when nominal ones would require long negotiations). These links break in liquidity trap as in such situation changes in money supply tend to just affect holding of money rather than encouraging investment or other spending.

However, government spending can still stimulate economy even in such situation. In fact, paradoxically in such situation government spending becomes extra potent because monetary policy that follows Taylor rule (or similar rule) usually works against government spending, because in normal situation such central bank would raise interest rates when government would pursue expansionary fiscal policy. Nonetheless, in situations as liquidity trap they reinforce each other because in such situations such central bank will keep its interest rate on the minimum possible level even if government pursues fiscal expansion (see discussion in Blanchard et al reference mentioned above, the Burda and Wyplosz in Macroeconomics ch. 10 have nice discussion of this or if you look for some more nuance then models in texts such as Romer Advanced Macroeconomics - although this is all contemporary treatment).

  • $\begingroup$ Congratulations and thank you for answering. $\endgroup$ – CountDOOKU Oct 31 '20 at 2:02
  • $\begingroup$ thanks, you are welcome. Also If you think this answer answered your question consider accepting it. $\endgroup$ – 1muflon1 Oct 31 '20 at 2:03
  • $\begingroup$ will do! I also asked a follow up question, only if you can take a look at that too! $\endgroup$ – CountDOOKU Oct 31 '20 at 2:05
  • $\begingroup$ Hi 1muflon1, can you briefly explain why "in normal situation such central bank would raise interest rates when government would pursue expansionary fiscal policy", why does changing interest rates work against government spending. Many thanks. $\endgroup$ – CountDOOKU Oct 31 '20 at 2:38
  • $\begingroup$ @Nhoj_Gonk because most monetary policy rules are Taylor-esque, and under Taylor rule central bank will set interest rate based on the gap between actual inflation and desired inflation and output gap. Government spending pushes up both inflation and output which will at some point force central bank that wants to keep stable prices to increase interest rate - which depressed the output. Of course, if central bank would be willing to play ball with government this would not happen but outside liquidity trap central bank that has mandate to keep stable prices will lean against gov. spending $\endgroup$ – 1muflon1 Oct 31 '20 at 2:45

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