Problem 2 (10 points) Symbols: = Up = Down — = No effect ? = Uncertain Use the a
ID: 1197755 • Letter: P
Question
Problem 2 (10 points)
Symbols: = Up = Down — = No effect ? = Uncertain
Use the above symbols to fill in the table below:
a) (5 points)
Observations
Effect on
Ms
Md
r
I
Y
C
The Fed decreases discount rate
The government implements stimulus package
Net effects
b) (5 points) What if the Fed buys government securities and the government increases spending at the same time? Show your reasoning.
Observations
Effect on
Ms
Md
r
I
Y
C
The Fed decreases discount rate
The government implements stimulus package
Net effects
Explanation / Answer
a)
When fed decreases discount rate (expansionary monetary policy), rate at which it lends to commercial banks decreases and makes loans affordable.
This increases investments which leads to increase in aggregate expenditure which inturn increases equilibrium Y, money supply in the economy Ms, r which is interest rate decreases. In this case Md and C (consumption) have no effect.
When government implements stimulus package (expansionary fiscal policy), i.e when G increases, aggregate expenditures increase and hence aggregate income (Y) increases. With increase in G, Y increases. But with increase in income demand for money Md increases and as demand increases for money interest rate r increases leading to higher costs of investments which decreases investments I. With increase in output (Y) demand for goods increases causing increasing in consumption (C).
As effect of expansionary fiscal policy effects money markets making investments to fall which is referred as crowding out effect, these repurcussions can be avoided if fed increases money supply when Y increases preventing rise of interest rates. Net effect is fed is accommodating expansionary fiscal policy to prevent crowding out and thus prevent fiscal policy from harming future growth
b)
When Fed buys government securities, it increases money supply, which decreases interest rate r, which leads to increase in investments I.
But as Y rises, due to increase in governmnet spendings and investments I, demand for money Md rises, which will push r back up just a little. Therefore r will not fall at a time by as much once we take both goods and money markets into account considering monetary and fiscal policies.