MONETARY POLICY

Monetary Policy



Monetary Policy

Question # 1

Analyse the 'liquidity trap' with reference to Keynes and Krugman and give examples how this concept applies to the current economic crisis in the UK?

Answer # 1

A simple and new debt-driven slump is the Keynesian style model that is used in situations when a debt overhang occurs on behalf of some other agents, who are enforced into some quick deleveraging, and affect the aggregate demand. In order to make some debt-constrained agents, there is an astonishingly influential assumption that is about: Fisherian debt inflation, the thrift paradox, the probability of a liquidity trap, a multiplier of Keynesian type, and an underlying principle for the fiscal policy that is expansionary and emerges logically from the model. This approach puts considerable emphasis on both the contemporary as well as the historical economic crisis, inclusive of the lost decade of Japan now after 18 years as well as the Great Depression itself (Buckley, 2004, p. 42).

The model of liquidity trap provides a rationale for viewing the liquidity trap as momentary, with regular conditions recurring once debt has been fully paid. As a consequence, it explains the reason that why a number of debts of public sector can be able to solve the problems that are caused by much of the debts of private sector. The function of fiscal expansion is performed for sustaining the employment and output while the balance sheets of private sector are repaired, and the government is able to pay down its personal debts soon after the deleveraging period ends.

In the economy of UK which is already flexible in terms of pricing, this downward adjustment of debt limit will direct the economy to a transitory fall in the rates of real interest. When the interest rates decrease then this temporarily negativity impacts the overall economy and, eventually the economy goes into economic crisis.

Question # 2

Discuss the IFE (International Fisher Effect) and illustrate it with the equivalence diagram. Outline the PPP (Purchasing Power Parity) theory and illustrate the theory with an example.

Answer # 2

The (IFE) i.e. normally known as International Fisher Effect and also referred to as open hypothesis of fisher in the international finance that makes suggestions about differences in the rates of nominal interest and reflect some anticipated variations in the exchange rate's spot among different countries. The hypothesis particularly states that the anticipation of change in the spot exchange rate is equivalent in the reverse direction of the rate of interest. Therefore, the country's currency with relatively superior rate of nominal interest is anticipated depreciating against the country's currency with the comparatively lower rate of nominal interest, as eventually the higher rates of nominal interests then leads to the inflation in the economy (Saunders & Cornett, 2009, p. 38). The derivation of the international Fisher effect is as follows:

, and can be arranged as:

Where,

 = the nominal interest rate

 = the real interest rate

 = the expected inflation rate

Equivalent diagram of International Fisher Effect

(PPP) i.e. known as Purchasing Power Parity is an economic theory ...