Answer to Question #274287 in Microeconomics for Ajeet Singh

Question

3. Given an economy with fixed prices, discuss the impacts of the following factors on the effectiveness of fiscal policy and monetary policy: i) degree of sensitivity of money demand to income (k), and

ii) degree of the sensitivity of interest to rate of interest (b).

Answer 1

It is known that stimulating fiscal policy is accompanied by an increase in equilibrium output and the effect of crowding out private sector investments. The smaller the displacement effect, the greater the increase in equilibrium output, the more effective, all other things being equal, the policy under consideration. The effectiveness of fiscal policy depending on the sensitivity of investments to the dynamics of the interest rate. The growth of public procurement (tax cuts) leads to an increase in the interest rate, which causes fluctuations in investment spending the greater the more sensitive investments are to the dynamics of the interest rate (i.e., the higher the parameter d). In turn, the greater the reduction in investment costs, the greater the displacement effect. With the same increase in the interest rate, investments are reduced more significantly. Thus, fiscal policy negatively depends on the sensitivity of investments to interest rate dynamics: this policy will be more effective when investments are not sensitive to changes in the interest rate in the money market (parameter d relative to ma), and less effective when they are relatively sensitive to the interest rate (parameter d is relatively large).the sensitivity of investments to the dynamics of the interest rate. The growth of public procurement (tax cuts) leads to an increase in the interest rate, which causes fluctuations in investment spending the greater the more sensitive investments are to the dynamics of the interest rate (i.e., the higher the parameter d). In turn, the greater the reduction in investment costs, the greater the displacement effect. With the same increase in the interest rate, investments are reduced more significantly. The effectiveness of fiscal policy depending on the sensitivity of the demand for money to the dynamics of the interest rate: given the sensitivity of investments to the interest rate, the change in investment expenditures accompanying fiscal policy will be determined by the magnitude of fluctuations in the interest rate: the interest rate with fluctuations in the demand for money due to changes in income changes the more significantly, the lower the sensitivity of the demand for money to its dynamics

When conducting a stimulating monetary policy, the increase in the money supply is aimed at reducing the interest rate. However, the reaction of the money market depends on the nature of the demand for money, i.e. on whether the demand curve for money is steep or flat. If the demand for money reacts strongly to changes in the interest rate (the value of the parameter h is large, the curve L(Y,r) is relatively flat), then the result of an increase in the money supply will be a slight decrease in the interest rate. If the demand for money reacts weakly to changes in the interest rate (the value of the parameter h is small, the curve L(Y,r) is relatively steep), then an increase in the monetary interest rate. If the demand for money reacts weakly to changes in the interest rate (the value of the parameter h is small, the curve L(Y,r) is relatively steep), then an increase in the money supply will lead to a significant decrease in the interest rate due to changes in income, the more significantly it changes, the lower the sensitivity of the demand for money to its dynamics. The sensitivity of money demand to income dynamics (parameter k) affects not only the slope of the curve, but also the magnitude of its shifts reflecting the impact of monetary policy.