Download Ch 12: C 1-6

CHAPTER 12: MONETARY AND FISCAL POLICY
Conceptual Problems
1.a. Open market operations involve the buying or selling of government bonds by the Fed. The
FRB in New York buys or sells U.S. government securities (generally via government bond
dealers) under the direction of the Federal Open Market Committee (FOMC). In an open
market purchase, the Fed buys bonds from the public in exchange for money. This action
increases the monetary base and subsequently 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. An open market sale affects the reserves that are available to banks and
therefore their ability to extend credit (make loans).
1.b. When the Fed undertakes open market sales, it exchanges government bonds for money. This
decreases the monetary base (bank reserves) and thus the ability of banks to generate loans.
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 (especially investment
spending) and therefore output contracts. The lower national income reduces money demand,
so interest rates decline again to some degree. But if prices are assumed to be fixed (as in the
IS-LM model), then interest rates still settle at a level higher than the original one. In an ISLM diagram, the LM-curve shifts to the left, leading to a higher interest rate and a lower
output level. In the longer run, the decrease in aggregate demand should cause a decrease in
prices, increasing real money balances. Therefore the negative effect on output is mitigated
in a model in which prices can vary.
2.
Monetary policy affects the economy by changing interest rates; however, if interest rates
cannot change, then monetary policy is rendered ineffective. This is the case in the liquidity
trap, when the LM-curve is completely horizontal. In this case, money demand is completely
interest elastic, that is, the parameter h in the money demand equation is assumed to be
infinitely large.
Monetary policy is also ineffective if the IS-curve is vertical, that is, if investment is
totally interest insensitive. This is called investment insufficiency. In this case, the parameter
b in the investment equation equals zero and the equation changes from
I = Io - bi
to
I = Io.
As a result the monetary policy multiplier is zero as monetary policy cannot affect the
level of investment spending.
The fiscal policy multiplier is zero if the LM-curve is vertical. This 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
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L = kY - hi
to
L = kY.
In the classical case, an increase in government spending has to be totally offset by a
decrease in private (interest sensitive) spending. Since money supply is fixed, money demand
cannot change, since otherwise the money sector cannot be in equilibrium. Therefore the
level of income has to stay at its original level.
Many economists believe that the likelihood that any of these three cases will occur is
fairly slim. However, some economists assert that economies were in, or at least close to, a
liquidity trap in the U.S. during the Great Depression, in Japan in the late 1990s, or even in
the U.S. during the 2007-09 recession.
3.
A liquidity trap is a situation in which, given a certain interest rate, the public is willing to
hold 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 IScurve) is clearly the better choice to 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). An increase in government purchases (G)
increases 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 that will occur. Similarly, the
more interest sensitive investment is, that is, the flatter the IS-curve is, the greater the degree
of crowding out that will occur. This implies that if the LM-curve is very steep or the IScurve is very flat, monetary policy will be more effective than fiscal policy in stimulating
national income.
Crowding out is more likely to occur when output is close to the full-employment level.
In this case, fiscal expansion will be reflected mainly in higher interest rates and prices, with
little effect on output. But when the economy is in a deep recession, fiscal expansion can
stimulate the economy successfully without much upward pressure on interest rates or prices.
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 are completely interest inelastic. After any type of
disturbance, a return to equilibrium in the money sector can only be accomplished through
changes in the level of output. In this situation, fiscal policy is completely ineffective, since
its initial effect is totally offset by the change in private spending resulting from a change in
the interest rate. On the other hand, monetary policy will achieve its maximum effect—but
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only in the short run. In the long run, the economy will always adjust back to the fullemployment level of output and monetary policy is neutral.
6.
Assume the government finances an increase in government purchases by borrowing from
the public, i.e., 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. This will cause more upward pressure on the price level. But as
the price level increases, real money balances will decrease, causing interest rates to rise
again. Therefore, in the long run, crowding out cannot be avoided by monetizing the deficit.
In a recession, when there is little inflationary pressure, such a fiscal/monetary policy mix
may be beneficial since it will cause a large increase in output while causing only a small
increase in prices. However, if the economy is close to full employment, we can expect a
significant increase in prices and interest rates with little impact on output. 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.
Neither a mix of restrictive fiscal policy and expansionary monetary policy nor a mix of
expansionary fiscal policy and restrictive monetary policy will significantly affect aggregate
demand or output. However, the first policy mix will decrease interest rates, while the second
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,
with output remaining roughly the same while interest rates are reduced. For example, a tax
increase will lower consumer spending but increase 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 output roughly the same, while increasing interest rates. This will decrease
the level of investment spending, while either government spending or consumption (if taxes
are cut) will increase.
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. This will make domestic goods more competitive on world markets
and lead 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.
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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 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: A tax increase can be combined with an investment subsidy,
in which case, the IS-curve would 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).
i
LM1
IS1
IS2
LM2
i1
i2
1
2
i3
3
0
Y2
Y1
Y
The adjustment process is as follows:
1-->2: TR ==> C  ==> Y == md  ==> i  ==> I  ==> Y . Effect: Y and i .
2-->3: (M/P)  ==> i  ==> I  ==> Y  ==> md  ==> i  Effect: Y  and i .
Combined effect: Y stays about the same while i goes down.
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
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interest rate constant, 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, the
LM-curve will not shift and the overall effect on income will be weakened, since the increase
in the interest rate will crowd out investment.
i
IS2
IS1
LM1
LM2
i2
2
i1
1
3
0
Y1
Y2
Y3
Y
The adjustment process is as follows:
1-->2: t  ==> C  ==> Y  == md  ==> i  ==> I  ==> Y  Effect: Y  and i .
2-->3: (M/P)  ==> i  ==> I  ==> Y  ==> md  ==> i 
Effect: Y  and i .
Combined effect: Y goes up while i stays 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 income and the interest rate. However, the
effects on the composition of GDP and on the investment schedule are not quite the same.
i
IS1
i
IS2
I1
LM
i1
i1
i2
i2
0
0
Y2
Y1
Y
I1 I2
I
An increase in the income tax rate will reduce consumption. The expenditure multiplier
will become smaller, so the IS-curve will become steeper and shift to the left. Due to the
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decrease in income, the money sector will no longer be in equilibrium (money demand will
have decreased), so the interest rate will have to decrease to again achieve a simultaneous
equilibrium in the expenditure and money sectors. The lower interest rate will increase
investment spending and we will move along the investment schedule from left to right.
Overall, we have a decrease in income and consumption but an increase in investment due to
lower interest rates. The adjustment process can be described as follows:
1-->2: t  ==> C  ==> Y == md  ==> i  ==> I  ==> Y . Effect: Y  and i .
Removing an investment subsidy will reduce the level of investment spending and shift
the investment schedule to the left. But this will shift the IS-curve parallel to the left by a
magnitude of IS = (Io). Due to the decrease in income, the money sector will no longer
be in equilibrium (money demand will have decreased), so the interest rate will decrease until
we are in a simultaneous equilibrium in the expenditure and money sectors. The decrease in
interest rate will increase investment spending again and we will move along the new
investment schedule from left to right. Thus the effect of the shift will be partially offset by
the decrease in the interest rate. Overall, we will have a decrease in the levels of income,
consumption, and investment.
i
IS1
i
IS2
I1
LM
I2
i1
i1
i2
i2
0
0
Y2
Y1
Y
I2
I1
I
This time, the adjustment process can be described as follows:
1-->2: Io  ==> Y == md  ==> i  ==> I  ==> Y . Effect: Y  and i .
4.
Expansionary monetary policy will 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 12-10.
Fiscal expansion will increase output and interest rates. The IS-curve will shift to the
right and a new equilibrium can be reached at point E1 in Figure 12-10.
Monetary expansion will increase spending on investment (due to lower interest rates)
and consumption (due to an increase in income). People or firms who would benefit from a
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reduction in interest rates or who advocate pro-growth policies clearly would favor this
policy change over fiscal expansion.
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 consumption, while decreasing
investment because of higher interest rates. People or firms who would benefit from an
increase in government spending or a tax cut clearly would prefer this policy over monetary
expansion. Conservatives tend to prefer a tax cut, while liberals tend to prefer increased
government spending on education, welfare, or work programs.
A more balanced growth can be achieved through an investment subsidy. This will shift
the IS-curve to the right and a new equilibrium will be reached at E1. But although 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. Clearly, businesses and people who own stock would be in favor of this
approach.
The full employment level of output can also be achieved through a mix of expansionary
monetary policy and expansionary fiscal policy. This will shift both the LM- and IS-curves to
the right and we will end up at Y*, somewhere between points E1 and E2 in Figure 12-10.
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