Project 02 answer Flashcards
This statement is incorrect for a number of reasons. In a closed economy, it is
incorrect because it neglects the multiplier and crowding-out effects. If the
government spends $5 billion, then this certainly has the direct effect of raising
aggregate demand by that amount. However, the multiplier effect will lead to more of
an increase in aggregate demand, while the crowding out effect will reduce the
impact on aggregate demand. The ultimate effect could be greater than or less than $5
billion, and is certainly not precisely predictable.
In a small open economy with perfect capital mobility, the statement is incorrect
because in addition to ignoring the multiplier and crowding-out effects it ignores the
influence of the exchange rate. If the central bank allows the exchange rate to vary
freely, then an increase in government spending causes the real exchange rate to
appreciate, which in turn crowds out net exports. The net effect is that the fiscal policy
has no lasting influence on aggregate demand. If the central bank seeks to maintain a
constant value for the exchange rate, the fiscal policy causes the bank to sell domestic
currency in the foreign currency exchange market and in this way expand the money
supply. This action eliminates the crowding-out effects on investment and net exports
leading to a larger increase in aggregate demand than experienced in a closed
economy. Again, however, the effect on aggregate demand is certainly not precisely
predictable.
This statement is incorrect for a number of reasons. In a closed economy, it is
incorrect because it neglects the multiplier and crowding-out effects. If the
government spends $5 billion, then this certainly has the direct effect of raising
aggregate demand by that amount. However, the multiplier effect will lead to more of
an increase in aggregate demand, while the crowding out effect will reduce the
impact on aggregate demand. The ultimate effect could be greater than or less than $5
billion, and is certainly not precisely predictable.
In a small open economy with perfect capital mobility, the statement is incorrect
because in addition to ignoring the multiplier and crowding-out effects it ignores the
influence of the exchange rate. If the central bank allows the exchange rate to vary
freely, then an increase in government spending causes the real exchange rate to
appreciate, which in turn crowds out net exports. The net effect is that the fiscal policy
has no lasting influence on aggregate demand. If the central bank seeks to maintain a
constant value for the exchange rate, the fiscal policy causes the bank to sell domestic
currency in the foreign currency exchange market and in this way expand the money
supply. This action eliminates the crowding-out effects on investment and net exports
leading to a larger increase in aggregate demand than experienced in a closed
economy. Again, however, the effect on aggregate demand is certainly not precisely
predictable.
Under restrictive monetary policy, the supply of money is reduced, and interest rates
will increase. Also, other credit conditions may further limit the amount banks and
other lenders are willing to lend. Within the housing market, an increase in interest
rates will likely reduce the number of people seeking mortgages, and may also restrict
the number of construction loans. This will likely reduce the demand for real estate
and reduce real estate prices.
The economic outlook for the economy and for the real estate market in
particular could lessen or even counteract the results of this monetary policy. For
example, if expectations are for further increases in house prices, then the demand
for housing may increase despite high interest rates.
In addition, contradictory fiscal policies could reduce the impact of a tight
monetary policy. For example, a federally sponsored program such as the Home
Buyer’s plan could be stimulating demand for real estate, effectively cancelling out
some of the effects of the restrictive monetary policy.
Under restrictive monetary policy, the supply of money is reduced, and interest rates
will increase. Also, other credit conditions may further limit the amount banks and
other lenders are willing to lend. Within the housing market, an increase in interest
rates will likely reduce the number of people seeking mortgages, and may also restrict
the number of construction loans. This will likely reduce the demand for real estate
and reduce real estate prices.
The economic outlook for the economy and for the real estate market in
particular could lessen or even counteract the results of this monetary policy. For
example, if expectations are for further increases in house prices, then the demand
for housing may increase despite high interest rates.
In addition, contradictory fiscal policies could reduce the impact of a tight
monetary policy. For example, a federally sponsored program such as the Home
Buyer’s plan could be stimulating demand for real estate, effectively cancelling out
some of the effects of the restrictive monetary policy.
Home owners have benefited from non-taxation of gains on house prices and some
other tax policies such as the Home Buyers’ Plan, grants to first time buyers, and
grants to purchasers of new housing. These policies increase the attractiveness of
ownership as opposed to renting and in many cases, relative to other financial assets
as well. The increase in demand for ownership units may cause increases in house
prices until the supply of units can be increased to meet the new demand.
Home owners with long-term mortgages have also benefited from inflation,
providing it was unexpected. Unexpected inflation is not calculated into the mortgage
rate and thus would cause the real dollar value of their fixed mortgage payments to
decrease. In other words, the borrower would repay the mortgage debt with dollars
that have decreased in value.
Home owners have benefited from non-taxation of gains on house prices and some
other tax policies such as the Home Buyers’ Plan, grants to first time buyers, and
grants to purchasers of new housing. These policies increase the attractiveness of
ownership as opposed to renting and in many cases, relative to other financial assets
as well. The increase in demand for ownership units may cause increases in house
prices until the supply of units can be increased to meet the new demand.
Home owners with long-term mortgages have also benefited from inflation,
providing it was unexpected. Unexpected inflation is not calculated into the mortgage
rate and thus would cause the real dollar value of their fixed mortgage payments to
decrease. In other words, the borrower would repay the mortgage debt with dollars
that have decreased in value.
The primary case for active monetary and fiscal policy to stabilize an economy is to
offset the harmful effects of economic fluctuations. These economic fluctuations can
result in unexpected expansions or contractions in the economy, which impose costs
on people and firms in the form of unemployment, inflation, and uncertainty. These
fluctuations may be caused by economic events such as war, changes in energy
prices, exchange-rate fluctuations, stock market booms or busts, or households and
firms becoming pessimistic.
The primary case for active monetary and fiscal policy to stabilize an economy is to
offset the harmful effects of economic fluctuations. These economic fluctuations can
result in unexpected expansions or contractions in the economy, which impose costs
on people and firms in the form of unemployment, inflation, and uncertainty. These
fluctuations may be caused by economic events such as war, changes in energy
prices, exchange-rate fluctuations, stock market booms or busts, or households and
firms becoming pessimistic.
The primary case against active monetary and fiscal policy to stabilize an economy is
that these policies have a long lag, and do not impact the economy immediately. For
monetary policy, because most households and firms make investment/spending
plans in advance, economists believe that a change in monetary policy can take six
months before it has much impact on employment or output. And once these changes
take effect, they can continue to impact the economy for years. This lag can be
considered a cause of economic fluctuations, rather than a cure.
For fiscal policy, the lag is primarily due to the political process. By the time a
change in federal spending or tax changes makes its way through the Canadian
political process, which can take months or years, the economic issues that were to be
addressed may have changed.
The primary case against active monetary and fiscal policy to stabilize an economy is
that these policies have a long lag, and do not impact the economy immediately. For
monetary policy, because most households and firms make investment/spending
plans in advance, economists believe that a change in monetary policy can take six
months before it has much impact on employment or output. And once these changes
take effect, they can continue to impact the economy for years. This lag can be
considered a cause of economic fluctuations, rather than a cure.
For fiscal policy, the lag is primarily due to the political process. By the time a
change in federal spending or tax changes makes its way through the Canadian
political process, which can take months or years, the economic issues that were to be
addressed may have changed.
Yes, aggregate demand can be stimulated without new stabilization policies. This is
achieved through autonomous means, via automatic stabilizers. Automatic
stabilizers are changes in fiscal policy that stimulate aggregate demand when the
economy goes into a recession, without policymakers having to take any deliberate
action. For example, the tax system is an automatic stabilizer. When the economy
goes into a recession, income, consumption, and profits all fall. Because taxes are a
function of these variables, tax revenue will also fall. This acts as an automatic tax cut
to households and firms, which increases aggregate demand and reduces the
magnitude of economic fluctuations.
Other automatic stabilizers include employment insurance and social assistance.
In times of recession, more people will apply for these benefits, this automatically
increases government spending which stimulates aggregate demand at the same time
when aggregate demand is insufficient to maintain full employment, i.e., no lag.
(Students may also explain how a flexible exchange rate can also act as an automatic
stabilizer).
Yes, aggregate demand can be stimulated without new stabilization policies. This is
achieved through autonomous means, via automatic stabilizers. Automatic
stabilizers are changes in fiscal policy that stimulate aggregate demand when the
economy goes into a recession, without policymakers having to take any deliberate
action. For example, the tax system is an automatic stabilizer. When the economy
goes into a recession, income, consumption, and profits all fall. Because taxes are a
function of these variables, tax revenue will also fall. This acts as an automatic tax cut
to households and firms, which increases aggregate demand and reduces the
magnitude of economic fluctuations.
Other automatic stabilizers include employment insurance and social assistance.
In times of recession, more people will apply for these benefits, this automatically
increases government spending which stimulates aggregate demand at the same time
when aggregate demand is insufficient to maintain full employment, i.e., no lag.
(Students may also explain how a flexible exchange rate can also act as an automatic
stabilizer).
