Answer to Question #318990 in Macroeconomics for Simran

Question

Ql.( a) Explain graphically the effect of increase in government expenditure on equilibrium level of income and interest rate in case of crowding out.

(b) Explain graphically how fiscal expansion can be accomodated by monetary expansion through IS, LM curves.

Answer 1

Ql.( a) 

Textbook macroeconomic theory holds that unless there are slack resources in the economy, an increase in government spending will put upward pressure on interest rates, thereby lowering consumer spending and business investment. But new empirical findings suggest that, at least at the local level, higher government spending actually may lead to a decline in interest rates.

In Effects of Fiscal Policy on Credit Markets, find that fiscal stimulus can not only expand output but can also contribute to lowering the cost of credit. They conclude that fiscal policy may therefore be able to push rates lower when monetary stimulus is constrained by interest rates at already-low levels raise, but also collected a compensation premium for having accepted a risky, lower-paying contract initially. This deferred-pay effect created more, a channel of fiscal policy transmission that has not been emphasized previously.

The researchers examine the effect of US Department of Defense (DOD) contracts on the interest rates prevailing in the cities in which the contract work was performed. Although US credit markets are integrated, local banks set their own rates for consumer loans. The researchers find that a 1 percent increase in expected DOD outlays from ongoing contracts, which may be interpreted as an injection of liquidity, is associated with a 0.24 basis point reduction in auto loan rates and a 0.30 basis point reduction in the rates charged for home equity lines of credit with a high loan-to-value ratio. In contrast, outlays associated with new production contracts have interest rate effects on auto loans that are an order of magnitude higher, with rates declining by 1.26 basis points in response to a 1 percent increase. The effect of new contracts on mortgage loan rates was small, and there was no statistically significant effect on credit card rates.

Outlays for new DOD production may raise the expected future income and wealth of city residents, which could in turn reduce default risk and hence the risk premium charged for riskier loans. This would be a more significant consideration for loans backed by riskier, less marketable collateral. In fact, a 1 percent increase in DOD outlays for new production reduced rates for riskier, less marketable, short-term used car loans by 3.08 basis points while reducing short-term loan rates for new cars by only 1.13 basis points.

The researchers suggest that their findings are explained by the notion that government spending relaxes credit markets through a liquidity injection and by reducing the perceived riskiness of borrowers. Even if an increase in outlays on a prior contract was expected, it could nevertheless represent an ongoing injection of liquidity into the local economy. As the earnings of local contractors rise, whether because of old or new outlays, local borrowers may become more creditworthy. Local banks may make more loans, their balance sheets may improve, and credit may expand along with their lending.

(b)IS-LM Intersection In the short run, the economy moves to the intersection of the IS and LM curves (figure 1). Production adjusts to demand to put the economy on the IS curve. Bond prices and the interest rate adjust to achieve equilibrium in financial markets, putting the economy on the LM curve.

Business-Cycle Fluctuation

A shift in either the IS curve or the LM curve can cause a business-cycle fluctuation. Different economic forces shift the IS and LM curves, so the curves shift independently. A change in aggregate demand shifts the IS curve but not the LM curve. A change in the demand or supply of money or bonds shifts the LM curve but not the IS curve.

Exogenous Price Level

For an economy in recession, Keynesians take the price level as exogenous. Any drop in the price level in response to excess supply is minimal.

Monetary Policy

Monetary policy is exogenous. With the price level taken as exogenous, the money supply sets the position of the LM curve. Monetary policy has no effect on the IS curve. Expansionary monetary policy shifts the LM curve down (figure 2). The money supply increases, and the interest rate falls. The economy moves down along the IS curve: the fall in the interest rate raises investment demand, which has a multiplier effect on consumption.

Fiscal Policy Fiscal policy is exogenous. The level of government expenditure and taxation and the tax code set the position of the IS curve. Fiscal policy has no direct effect on the LM curve. Increased government spending or a tax cut is assumed to be financed by borrowing. The money supply does not change, so the LM curve does not change.

Expansionary fiscal policy shifts the IS curve to the right (figure 3). The multiplier effect on consumption raises the national income and product. The increase in the interest rate partially offsets the expansionary effect.

Disequilibrium, not Equilibrium

The Keynesian IS-LM model is a model of disequilibrium, not equilibrium. The IS curve does not represent the condition that demand equals supply for goods. Instead the IS curve represents the condition that demand equals product. There is excess supply, with demand and product less than supply.

Stocks, Not Flows

The LM curve deals with stocks, not flows. Portfolio demand and supply set the position of the LM curve. The LM curve is entirely independent of desired investment and saving. Instead these factors influence the IS curve. Desired saving is not the demand for bonds; a flow cannot equal a stock. Desired investment is not the supply of bonds.

Aggregate Demand Curve

The aggregate demand curve is a construction derived from the IS-LM model. A given price level P fixes the real money supply M/P, which sets the LM curve. The national income and product determined by the IS-LM intersection can then be seen as a decreasing function of P. If P falls, the real money supply M/P rises. The LM curve shifts down, so y rises.

Aggregate Demand and Supply

Aggregate supply is just the productive capacity of the economy at full employment and is taken as exogenous. In recession, aggregate demand is less than aggregate supply (figure 4).

Increased Aggregate Demand

Consider a given price level P. An autonomous increase in aggregate demand shifts the IS curve right. National income and product increase, as the IS-LM intersection moves to the right and up. Hence the aggregate demand curve shifts right.