Macroeconomics

Session 10

11-1
 Fiscal Policy and Crowding Out
• Recall:
• IS curve describes the equilibrium in which market

• Slope of the IS curve

• How interest rates affect the level of output

11-2
 Fiscal Policy and Crowding Out
• The equation for the IS curve is: Y  G ( A  bi ) (3)
• The fiscal policy variables, G and t, are within this definition
® Fiscal policy actions, changes in G and t, affect the IS curve

• Suppose G increases
• At unchanged interest rates, AD increases
• To meet increased demand, output must increase
• At each level of the interest rate, equilibrium income must rise
by G G

11-3
 Fiscal Policy and Crowding Out
• If the economy is initially in
equilibrium at E, if
government expenditures
increases, equilibrium
moves to E”

Interest Rate
• The goods market is in
equilibrium at E”, but the
money market is not:
• Because Y has increased,
the demand for money also
increases  interest rate
increases Income, Output
• Firms’ planned investment
spending declines at higher
interest rates and AD falls
off  move up the LM
curve to E’
11-4
 Fiscal Policy and Crowding Out
• Comparing E to E’:
increased government
spending increases income
and the interest rate
Comparing E’ to E”:

Interest Rate
•
adjustment of interest rates
and their impact on AD
dampen expansionary effect
of increased G
• Income increases to Y’ instead Income, Output
of Y”
Increase in government
expenditures
crowds out investment spending.
11-5
 What factors determine CO effect
• The flatter the LM
schedule:
• Income increases more
• Interest rates increase

Interest Rate
less

Income, Output

11-6
 What factors determine CO effect
• The flatter the IS
schedule:
• Income increases less
than the interest rate

Interest Rate

Income, Output

11-7
 The Case of Liquidity Trap
• An increase in
government spending
has its full multiplier
effect on the

Interest Rate
equilibrium level of
income
• No effect on interest
rates
Income, Output

11-8
 The Classical Case
• An increase in
government spending
has no effect on the
equilibrium level of

Interest Rate
income
• It increases only the
interest rates
Income, Output

11-9
 3 Important Points (1)
• Crowding out through a different mechanism
• Two assumptions:
• Prices are given
• Output is below the full employment level

• What if output has reached the full employment level?

• Increased AD increases prices
• Increased prices reduces real balances
• Reduced real money supply shifts LM curve to left
• Increased interest rates
• Thus, initial increase in AD is crowded out
11-10
 3 Important Points (2)
• Incomplete crowding out effect

• When output is below full employment level

• Increased govt. spending increases interest rates as well as
income
• Increased income raises savings
• Increased savings makes it possible to finance a larger BD
• Private investment is not completely crowded out

11-11
 3 Important Points (3)
• What if monetary
authorities accommodate
fiscal expansion?

• Monetary accommodation

Interest Rate
is also referred to as
monetizing budget deficits ,
meaning that the Federal
Reserve prints money to
buy the bonds with which
Income, Output
the government pays for its
deficit.

11-12
 The Composition of Output
and the Policy Mix
• Below Table summarizes our analysis of the effects of expansionary monetary
and fiscal policy on output and the interest rate (assuming not in a liquidity trap
or in the classical case)
• Monetary policy operates by stimulating interest-responsive components of AD
• Fiscal policy operates through G and t  impact depends upon what goods the
government buys and what taxes and transfers it changes
• Increase in G  increases C along with G; reduction in income taxes increases C

11-13
 The Composition of Output
and the Policy Mix
• Figure shows the policy problem of
reaching full employment output,
Y*, for an economy that is initially
at point E, with unemployment
• Should a policy maker choose:
 Fiscal policy expansion, moving
to point E1, with higher income

Interest Rate
and higher interest rates
 Monetary policy expansion,
resulting in full employment
with lower interest rates at point
E2
 A mix of fiscal expansion and
accommodating monetary policy Income, Output
resulting in an intermediate
position

11-14
 The Composition of Output
and the Policy Mix
• All of the policy alternatives
increase output, but differ
significantly in their impact on
different sectors of the economy
• Given the decision to expand
aggregate demand, who should get
the primary benefit?

Interest Rate
• An expansion through a decline in
interest rates and increased
investment spending?
• An expansion through a tax cut and
increased personal consumption?
• An expansion in the form of an
increase in the size of the Income, Output
government spending?

11-15