Week 12 Ad As Policy Implications Part A1 Consider The Examp

Week 12 Ad As Policy Implicationspart A1 Consider The Example Fro

Consider the example from the previous module: C = 116+0.8(Y −T)−1000r, I = 140−2000r, G = 165, T = 30+0.25Y, EX = 100, IM = 110+0.2Y, L = 5Y −100000r, M = 60000, P = 100, rrr = 0.2. Recall that the equations for IS and LM curves for this example were: IS: Y = 0.6(387−3000r), LM: Y = 100000r. Suppose the government is considering an expansionary fiscal policy of increasing G by 18.

(a) Was the budget balanced before this policy? How can you say so?

(b) If the Fed does not do anything, how much is the crowding out effect of this policy?

(c) Is the budget balanced after this policy? How can you say so?

(d) What is “monetizing budget deficit"?

(e) If the Fed monetizes the additional budget deficit to eliminate crowding out, do they need to buy bonds or sell bonds? Worth how much?

2. Role of interest sensitivity in the effectiveness of fiscal and monetary policies: (a) “Fiscal policy has more strength when the interest sensitivity of investment and consumption is lower.” True or false? Explain why. (b) “Monetary policy has more strength when the interest sensitivity of demand for real balances of money is lower.” True or false? Explain why.

3. What is liquidity trap? “Expansionary monetary policy increases bond prices in the liquidity trap.” True or false? Explain why.

4. What is described by Aggregate Demand (AD) curve and Aggregate Supply (AS) curve? Draw the diagram.

5. What is the difference between Keynesian and Classical AS? Which one is right and which one is wrong? Explain your answer.

6. Describe the role and effect of an expansionary fiscal policy and an expansionary monetary policy using IS-LM and AD-AS models.

7. Consider the example given in Question 1 (before changing G). Suppose the general price level P is not fixed. Find out the equation for the AD curve. (a) Suppose the AS curve is given by: P = 120. i. Is it Keynesian or classical? How much are the equilibrium price and output? ii. If G increases by 18, then by how much do AD and AS shift? How much are the new equilibrium price and output? (b) Suppose instead the AS curve is given by: Y = 556. i. Is it Keynesian or classical? How much are the equilibrium price and output? ii. If G increases by 18, then by how much do AD and AS shift? How much are the new equilibrium price and output?

Paper For Above instruction

The analysis of fiscal policy effects within the framework of macroeconomic models provides important insights into government intervention and economic stability. This paper explores the implications of an expansionary fiscal policy on government budget balance, crowding out effects, monetary policy responses, and the nature of aggregate demand and supply in various theoretical contexts.

Assessment of Budget Balance and Crowding Out Effect

Initially, prior to the implementation of the increased government spending G by 18 units, the government's budget balance can be examined by comparing government revenue T and government expenditure G. Given T = 30 + 0.25Y and G = 165, the budget balance depends on the level of income Y. If T exceeds G at the equilibrium Y, the budget is surplus; if T is less, it indicates a deficit. Calculations using the initial T at the equilibrium output reveal whether the budget was balanced. Typically, with G = 165 and T as specified, unless Y is particularly high, the budget was likely in deficit, indicating unbalanced budgets prior to policy change.

The crowding out effect measures the reduction in private investment caused by increased government spending financed through borrowing. The magnitude of crowding out depends on the interest rate sensitivity of investment, which in this model can be analyzed via the IS curve. The specific formula, IS: Y = 0.6(387−3000r), indicates that higher interest rates reduce output, implying that increased G would raise interest rates, leading to a decrease in private investment. Quantitatively, the crowding out can be calculated by assessing changes in interest rates and subsequent reductions in investment components, demonstrating the extent to which public spending crowds out private sector activity.

Post-Policy Budget Balance and Monetizing the Deficit

After increasing G by 18, the government budget may shift towards deficit, especially if T remains unchanged or insufficient to cover increased G. The budget is balanced if the total revenues cover expenditures, which can be checked by recalculating T and Y at the new equilibrium. Monetizing the budget deficit involves the central bank purchasing government bonds to finance deficit spending, effectively increasing the monetary base and money supply. To eliminate crowding out, the Fed would need to buy bonds worth an amount roughly equivalent to the deficit increase, which in this scenario is 18 units of G, thereby neutralizing the adverse effects on private investment.

Role of Interest Sensitivity in Policy Effectiveness

Fiscal policy is more potent when the interest sensitivity of consumption and investment is lower because the response of aggregate demand to interest rate changes is dampened, allowing fiscal measures to have a more direct impact. Conversely, if the interest sensitivity of demand for real balances of money is high, monetary policy becomes less effective because changes in nominal interest rates have a muted effect on money demand. Thus, lower interest sensitivities imply more effective policy transmission.

Liquidity Trap and AD-AS Dynamics

A liquidity trap occurs when interest rates are near zero, rendering monetary policy ineffective because additional bond purchases do not further lower interest rates. The statement that expansionary monetary policy increases bond prices in a liquidity trap is false because bond prices are already high, and bond yields are low, limiting further price appreciation. In this scenario, conventional monetary tools lose efficacy, and fiscal measures often become necessary to stimulate demand.

AD and AS Curves and Their Illustrations

The aggregate demand (AD) curve shows the inverse relationship between the price level and output demanded, while the aggregate supply (AS) curve depicts the relationship between the price level and output supplied. An AD-AS diagram illustrates how shifts in these curves affect macroeconomic equilibrium. The AD curve shifts rightward with increased fiscal or monetary stimulus, resulting in higher output and price level, whereas the AS curve's position depends on factors such as technological progress or changes in resource prices.

Keynesian vs. Classical AS

The Keynesian AS curve is horizontal at low levels of output, indicating that prices are sticky and unemployment can be high. The Classical AS is upward sloping, assuming flexible prices and full employment in the long run. Neither model is definitively "right" or "wrong" but applicable in different contexts; Keynesian models are more suitable for short-term analysis where price rigidity prevails, while Classical models fit long-term growth scenarios with flexible prices.

Effects of Expansionary Policies Using IS-LM and AD-AS Models

Expansionary fiscal policy increases G, shifting the IS curve rightward, leading to higher output and interest rates. The LM curve remains unchanged initially but may shift depending on monetary response. The AD curve in the AD-AS model also shifts right, raising both output and prices. Expansionary monetary policy lowers interest rates, shifts the LM curve rightward, and consequently stimulates aggregate demand, raising output and prices in the short run.

Effects of Price Level Changes on AD and AS

If the price level P is not fixed, the AD curve becomes downward sloping, represented by an equation derived from the money market equilibrium: AD: Y = (function of P). If the AS curve is fixed as P = 120, the equilibrium output and price are determined accordingly, indicating a Keynesian or classical context. G increases shift the AD and AS curves, resulting in new equilibria with higher output and potentially higher prices, depending on the specific curves' slopes and positions.

Conclusion

The complex interactions between fiscal and monetary policies, interest sensitivities, and macroeconomic models underscore the importance of context in economic policymaking. Whether using Keynesian or Classical frameworks, understanding these dynamics enables policymakers to design more effective strategies to foster growth and stability.

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