Macro 14 - Evaluating Fiscal and Monetary Policy

Question 1

Positive side effects of demand-side policies

Answer 1

1. Although the gov. may need to increase debt to inject into the CF, one may argue that the subsequent growth that follows (e.g. increased tax revenue) will exceed this.
2. May be beneficial to supply (SRAS). Fiscal: increase in gov. spending + decrease in tax = increased consumption so firms may grow and benefit from economies of scale, reducing costs of production. Short-run impact is likely to be inflationary. If G is on education, then productivity increases, lowering costs of production. Monetary: decrease in IRs = increased investment due to lower OC = increase in FoPs so become less scares and lowers costs of production.
3. Beneficial to LRAS. Fiscal: increase in G on infrastructure and capital = increase in quality/quantity of FoPs. G on education or subsidising training courses for firms increases quality of labour. Monetary: lower IRs = increased investment = increased FoPs.

Question 2

Problems/evaluation - demand-side policies

Answer 2

1. If the economy is nearing full-capacity or at full capacity, an increase in AD with cause an increase in the rate of inflation. Trade-off. Especially if multiplier effect occurs.
2. If the economy is already at NAIRU, then an increase in AD will cause an increase in inflation. This can be illustrated by drawing a classical AD, LRAS, SRAS curve parallel to a LRPC and SRPC operating initially at the NAIRU.
3. If the NAIRU is higher than the government wants then policies which shift the LRAS to the right would be better as this willshift the LRPC to the left.
4. Business and consumer affects the multiplier effect and responsiveness to interest rate reduction and consequently, the effectiveness of demand side policies.

Question 3

Fiscal Policy Evaluation - crowding out effect

Answer 3

> If the government has to borrow money to spend, they may crowd out the private sector.
The government needs to sell bonds (to facilitate spending/borrow money) which means they are demanding more and more loanable funds. This price of loanable funds is just the in interest rate.
When the gov. increases borrowing, D1 shifts to D2, which increases interest rates in the market (on an S-D diagram with interest rate on y-axis, Q on x-axis).
The increase in interest rates is likely to be transferred to loans in general. The more demand there is for these loanable funds or just loans in general, it will increase the price on them and so the interest rate on them.
So ordinary, private firms who need to borrow money to fund investment will have to pay more in terms of interest, which may hold back investment, which can hold back AD, which can hold back growth.

Question 4

Crowding out - summary

Answer 4

> Crowding out reduces the impact of expansionary fiscal policy, but may also be less allocatively efficient if investment is directed away from private towards public investment as may lead to a decrease in dynamic efficiency.

Question 5

Crowding out - definition

Answer 5

> A situation where increased public investment and government spending leads to a reduction in availability of funds and increased interest rates for private investment and consumption.

Question 6

Concern regarding government spending

Answer 6

> If the government don’t see immediate changes in GDP after increasing gov. spending, they may keep injecting and then we may see a rapid increase in inflation once it kicks in.
Time lag.
To avoid overspending and triggering inflation when using fiscal policy it’s useful to consider the size of the multiplier, the mpc, level of business/consumer confidence.
If budget deficit is really large, it could be harmful to the government’s ability to raise funds for fiscal policy in the future (credit score). Future generations may face cuts and higher taxes if debt is very large.