Download CHAPTER 11 MONETARY AND FISCAL POLICY Solutions to the

CHAPTER 11
MONETARY AND FISCAL POLICY
Solutions to the Problems in the Textbook:
Conceptual Problems:
1.a. An open market operation is an exchange of bonds for money or vice versa by the Fed. In an open
market purchase, the Fed buys bonds from the public (generally via government bond dealers) in
exchange for money. This action increases the monetary base and therefore the supply of money. In
an open market sale, the Fed sells bonds in exchange for money, decreasing the monetary base and
therefore the supply of money.
1.b. When the Fed undertakes open market sales, it exchanges bonds for money. This decreases the
monetary base and the resulting decrease in money supply creates a portfolio disequilibrium. The
public adjusts by selling other assets, so asset prices decrease and yields (interest rates) increase. This
increase in interest rates has a negative effect on aggregate demand (investment spending) and output
contracts. A lower level of national income reduces money demand and therefore interest rates
decline again. But if the price level is assumed to be fixed (as in the IS-LM model), then interest rates
still settle at a level higher than the original one. Overall, in an IS-LM diagram, the LM-curve shifts
to the left, leading to a higher level of interest rates and a lower level of income.
2. The IS-curve is vertical, if investment spending is totally interest insensitive. This is called investment
insufficiency; in this case the monetary multiplier is zero. Since the parameter b in the investment
equation equals zero, the equation changes from
I = Io - bi
to I = Io.
A horizontal LM-curve will also render monetary policy ineffective. This is called the liquidity
trap. In this case, money demand is totally interest elastic, and the parameter h in the money demand
equation is assumed to be infinitely large.
The fiscal policy multiplier is zero if the LM-curve is vertical. This case is called the classical
case, and money demand (and money supply) is assumed to be totally interest insensitive. Since the
parameter h in the money demand equation equals zero, the equation changes from
L = kY - hi
to
L = kY.
None of these three cases is very likely to occur. However, some economists assert that Japan in
the late 1990’s and the U.S. in the Great Depression were in, or close to, the liquidity trap.
3. A liquidity trap is a situation in which the public is willing to hold, at a given interest rate, however
much money the Fed is willing to supply. In this case, the LM-curve is horizontal and monetary
policy is totally ineffective. Fiscal policy (which will shift the IS-curve) is clearly the better choice to
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stimulate the economy in such a situation, since no crowding out will occur. This means that fiscal
policy will have its maximum effect.
4. Crowding out occurs when an increase in government spending raises interest rates, which reduces
private spending (especially investment). For example, an increase in government purchases (G) will
increase income (Y) and therefore consumption (C); but because the interest rate (i) will increase, the
level of investment spending (I), and most likely also net exports (NX), will decrease, changing the
composition of GDP. Some degree of crowding out will always occur as long as the LM-curve is
upward sloping, that is, in all cases except the liquidity trap. The steeper the LM-curve is, the greater
the degree of crowding out. This implies that if the LM-curve is steep monetary policy will be more
effective than fiscal policy in stimulating national income.
5. In the classical case, the LM-curve is vertical at the full-employment level of output. In this case,
money demand (and money supply) would be completely interest inelastic. After any type of
disturbance, a return to an equilibrium in the money sector could only be accomplished through
changes in the level of output. In this situation, fiscal policy would be completely ineffective, since it
would be totally crowded out. On the other hand, monetary policy would achieve its maximum effect.
6. Assume the government finances an increase in government spending by borrowing from the public
(the Treasury sells government bonds to finance the increase in the budget deficit). The increase in
the demand for credit by the government will lead to an increase in interest rates. If the Fed is worried
about high interest rates, it may monetize the budget deficit, that is, buy the government bonds that
the public now holds. This will inject money into the economy, and interest rates will drop again, so
no crowding out of private spending may occur, at least in the short run.
In an IS-LM model, the expansionary fiscal policy will shift the IS-curve to the right, while the
Fed’s action will shift the LM-curve to the right. This means that the AD-curve will shift further to
the right than would have been the case if the Fed had not accommodated the expansionary fiscal
policy. But this causes more upward pressure on the price level. In a recession, when there is little
inflationary pressure, such a fiscal/monetary policy mix may be beneficial and cause only a small
increase in the price level. However, if the economy is close to full employment, then we can expect a
significant increase in the price level. In the long run, when the AS-curve is vertical, there will be
total crowding out, whether the Fed monetizes the increase in the budget deficit or not.
7. A combination of restrictive fiscal policy and expansionary monetary policy will not significantly
affect aggregate demand or income, and neither will expansionary fiscal policy combined with
restrictive monetary policy. However, the first policy mix will decrease interest rates, while the latter
will increase interest rates. Therefore the composition of output will be different in each case.
The first combination will shift the IS-curve to the left and the LM-curve to the right, in which
case income will remain roughly the same while interest rates will be reduced. A tax increase will
lower consumption while increasing investment spending due to lower interest rates. The second
combination will shift the IS-curve to the right and the LM-curve to the left, leaving income roughly
the same, while increasing interest rates. This will decrease the level of investment spending, while
either government spending or consumption (through a tax cut) will increase.
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Other considerations may involve the effect of a given policy mix on the budget surplus and the
value of the dollar (and therefore net exports). The first policy mix will increase the budget surplus.
Lower interest rates may also lead to an outflow of funds, which will lower the value of the dollar,
leading to an increase in net exports. The second policy mix will decrease the budget surplus. Higher
interest rates may lead to an inflow of funds, which will increase the value of the dollar, leading to a
decrease in net exports.
Technical Problems:
1. If the government wants to change the composition of GDP towards investment and away from
consumption without changing the level of aggregate demand, it needs to implement a combination of
restrictive fiscal policy and expansionary monetary policy. An increase in personal income taxes or a
decrease in transfer payments will reduce consumption and thus aggregate demand. The IS-curve will
shift to the left, leading to a decrease in the level of output and the interest rate. To increase output to
its original level, the Fed can undertake expansionary monetary policy. This will shift the LM-curve
to the right, leading to a further decrease in the interest rate, thus stimulating investment, and, in turn,
aggregate demand. If the intersection of the new IS- and LM-curves is at the same income level as
previously, then the decrease in the interest rate will have stimulated investment spending sufficiently
to exactly offset the decrease in consumption. (Note: The tax increase can be combined with an
investment subsidy. In this case, the IS-curve will not shift as far to the left as before.)
The following diagram shows the effect of a decrease in transfer payments (TR) that is combined
with an increase in money supply (M/P). The adjustment process is as follows:
1-->2: TR ==> C  ==> Y == md  ==> i  ==> I  ==> Y . Effect: Y  and i .
2-->3: (M/P) up ==> i  ==> I  ==> Y  ==> md  ==> i  Effect: Y  and i .
Combined effect: Y about the same and i .
i
IS1
LM1
IS2
LM2
1
i1
2
i2
3
i3
0
Y2
Y1
Y
2. A cut in the income tax rate will flatten the IS-curve and shift it to the right. Both the level of
income and the interest rate will increase. If the Fed increases money supply to keep the interest
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rate constant, then the LM-curve will also shift to the right, maximizing the multiplier effect,
since no crowding out will take place. However, if money supply is held constant, then the LMcurve will not shift and the overall effect of this fiscal expansion on income will be weakened,
since the increase in the interest rate will crowd out investment.
i
IS2
IS1
LM1
LM2
2
i2
1
3
i1
0
Y1
Y2
Y3
Y
The adjustment process is as follows:
1-->2: t  ==> C  ==> Y  == md  ==> i up ==> I  ==> Y down.
2-->3: (M/P)  ==> i  ==> I  ==> Y  ==> md  ==> i 
Effect: Y  and i .
Effect: Y  and i .
Combined effect: Y  and i about the same.
3. Either a removal of an investment subsidy or an increase in the income tax rate will shift the IS-curve
to the left. This will lead to a decrease in the level of income and the interest rate. A rise in the
income tax rate will reduce consumption, but investment will increase due to the decrease in the
interest rate. Removing an investment subsidy will reduce investment, but the effect will be partially
offset by the decrease in the interest rate. The decrease in income will lead to a decrease in
consumption.
i
IS1
i
IS2
LM
I1
I2
i1
i1
i2
i2
0
0
Y2
Y1
Y
I2
4
I1
I
Note: An increase in the income tax rate will decrease the multiplier. The IS-curve will not only shift
to the left but will also become steeper. The removal of an investment subsidy, as shown in the
textbook, will lead to a parallel shift of the IS-curve to the left. Here, only a parallel shift is shown.
4.
Monetary expansion will lead to lower interest rates, which will stimulate investment and thus output.
The LM-curve will shift to the right, and a new equilibrium will be reached at point E2 in Figure 11-8.
Fiscal expansion will lead to a higher level of output and higher interest rates. The IS-curve will shift
to the right and a new equilibrium can be reached at point E1 in Figure 11-8.
Fiscal expansion through an increase in government purchases will allow public spending as a
share of GDP to increase, while private spending (especially investment) as a share of GDP will
decline. A reduction in income taxes will increase the level of consumption, while decreasing the
level of investment because of higher interest rates. Monetary expansion will increase the level of
investment spending (due to lower interest rates) and consumption (due to higher income).
A more balanced growth can be achieved through an investment subsidy. This will shift the IScurve to the right and a new equilibrium will be reached at E1. But even though interest rates will rise,
the impact of the investment subsidy will not be totally lost. Here we have an example in which both
consumption, induced by higher income, and investment, induced by the subsidy, will rise.
Full employment can also be achieved through a combination of expansionary monetary and
expansionary fiscal policy. This will shift both the LM- and IS-curves to the right and we will end up
somewhere between points E1 and E2 in Figure 11-8.
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