Use an IS-LM diagram to illustrate Krugman’s contention that fiscal policy is more effective as a macroeconomic policy tool when compared to monetary policy, given that the economy is in a liquidity trap.
The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that demonstrates the relationship between interest rates and real output, in the goods and services market and the money market (also known as the assets market). The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves is the "general equilibrium" where there is simultaneous equilibrium in both markets. Krugman thinks that fiscal policy is a powerful tool that affects the economy. If government spends more, total spending in the economy goes up. That increases the sales of businesses, which respond by hiring more workers. The result: more income and more work. Less government spending has the opposite effect. Higher taxes leave people with less money to spend and that has a depressing effect on economic activity. Lower taxes do the opposite. In a liquidity trap monetary policy becomes completely ineffective. The central bank can shower trillions of dollars on the economy and it won’t matter. People will simply put the money in their pockets and not spend it. By contrast, fiscal policy is hugely effective. In fact, government spending is helpful even if it is completely wasteful.