Unit 4.5 fiscal policy debates

Question 1

List the current issues that affect fiscal policy

Answer 1

1. Crowding out effect
2. Monetary policy accommodation
3. Fiscal policy in an open economy
4. Fiscal policy in a monetary union

Question 2

Crowding out effect explained

Answer 2

IS curve: combination of output (Y) and interest rate (r) that results in a product market equilibrium. Downward-sloping relationship through investment (borrowing gets more expensive -> less durable goods -> Less Y (outputs)

LM curve: combination of Y and r that results in money market equilibrium for a fixed money supply -> the positive relationship between Y and r relies on the demand for money (L(Y,r) which is:
- An increasing function of Y (with more output circulating, more money is needed for transactions)
- A decreasing function of r (as the interest rate grows, private agents prefer to hold interest-bearing assets rather than cash)
- So when there is more Y, there will be more money demand

Fiscal expansion -> an IS shift to the right (because of the additional demand for goods, output is larger for any given interest rate)

More liquidity demand but not same monetary base -> r increase -> there is a partial crowing-out of private demand by public demand

Question 3

Monetary policy accommodation

Answer 3

Maintain or lower the interest rate -> increase investment and aggregate demand -> strengthens multiplier

Dangers: it can lead to governments to pressure the central bank to make the monetary policy follow the fiscal policy and result in inflation

+ graph

Question 4

Fiscal policy at the zero lower bound

Answer 4

• Zero lower bound: when the policy-determined interest rate remains at or near 0, whereas the economic situation would justify setting it at a significantly negative level (but it’s not possible to do so with monetary policy).
• In this situation, it’s as if monetary policy were fully accommodative of the fiscal policy without doing anything. This magnifies the effects of fiscal expansion
  +graph

Question 5

Fiscal policy in an open economy

Answer 5

• Openness of goods & services -> X is part of the aggregate demand
• Other things to consider:
  1. Exchange rate:
  flexible -> the price of domestic currency in terms of a foreign currency fluctuates freely with the market
  fixed -> the central bank has to defend a fixed price
  2. Financially open countries -> capital flows will be attracted to the higher interest rate, in equilibrium, their interest rates will have to be equal
• Financially closed countries -> their interest rates can differ, as this will not cause capital flow imbalances

Question 6

Fiscal policy in a monetary union: spillover effects

Answer 6

• From the point of view of he neighbour of a country that does a fiscal expansion, there are 2 opposing forces:
  +r (for everyone with the same currency) -> - Y
  + X (coming from + IM of the country that had a fiscal expansion) -> + Y
• Moreover, the size of the country that does the expansion i relevant:
  Small -> little impact on the union’s r: less benefit to oneself (because the ratio of IM to Y is large due to reliance on imports)
  Big -> large impact on the union’s r; more benefit to oneself (because most consumption is national)