Transcript Policy Lags and Crowding-Out Effect

Policy Lags and
Crowding-Out Effect
Unit 5 Lesson 1
Activities 43 & 44
Goodman, Rae Jean B.. U.S. Naval Academy
Advanced Placement Economics Teacher Resource Manual.
National Council on Economic Education, New York, N.Y
Objectives
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Explain inside and outside lags for monetary and
fiscal policy.
Define the crowding-out and the Barro-Ricardo
effect.
Explain the effects of crowding-out within the
short-run AD and AS model.
Explain how the Barro-Ricardo effect can reduce
the crowing-out effect while simultaneously
reducing the effects of the fiscal policy.
Demonstrate the use of monetary policy to
lessen or reinforce the crowding-out effect.
Introduction
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This lesson discusses the lags associated with
monetary and fiscal policy making and analyzes
the direct and indirect effects of government
budget deficits.
The direct effect of these deficits is an increase
in interest rates.
When the government borrows money to
finance its deficit, this results in an increase in
the demand for money, or, alternatively, the
demand for loanable funds. This in turn results
in an increase in the interest rate.
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A higher interest rate causes decreases in
investment and other interest sensitive
components of AD.
Crowding-out is the decrease in private
demand for funds that occurs when the
government’s demand for funds causes
the interest rate to rise:
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The demand by government for loanable
funds decreases or crowds-out the private
demand for loanable funds.
Lags Associated With Policy Making
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The inside lag consists of the time it takes
for data to be collected, policy makers to
recognize that policy action is necessary,
the decision about which policy should be
taken and the implementation of the
policy.
The outside lag is the time it takes the
economy to respond to the new policy.
These lags differ in length for monetary
policy and fiscal policy.
Activity 43: Monetary and Fiscal Policy
Part A: Tools of Monetary and Fiscal Policy
 Both monetary and fiscal policy can be
used to influence the inflation rate and
real output. Indicate what effect each
specific policy has on inflation and real
output in the short-run (9 to 18 months).
Monetary Policy
1. (A) Buy government securities
(B) Sell government securities
2. (A) Decrease the discount rate
(B) Increase the discount rate
3. (A) Decrease reserve requirement
(B) Increase reserve requirement
Inflation
Real Output
Increase
Increase
Decrease
Decrease
Increase
Increase
Decrease
Decrease
Increase
Increase
Decrease
Decrease
Fiscal Policy
4. (A) Increase government spending
Inflation
Real Output
Increase
Increase
Decrease
Decrease
Decrease
Decrease
Increase
Increase
(B) Decrease government spending
5. (A) Increase taxes
(B) Decrease taxes
Part B: Lags in Policy Making
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As the economic situation changes, policy
makers must decide when to take action
and what policy action to take. Then they
must implement the policy.
The economy then responds to the policy.
The amount of time it takes policy makers
to recognize and take action is called
inside-lags.
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The amount of time it takes the economy
to respond to the policy changes is called
outside or impact lags.
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The inside lag is estimated to be short for
monetary policy, but long for fiscal policy.
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The inside lag is long for fiscal policy because
the legislative branch must come to
agreement about the appropriate action.
The outside lag, however, is long and
variable for monetary policy but very short
for the fiscal policy.
6.
Explain why the inside lag can be short
for monetary policy, but the outside lag
is long and variable.
The Federal Reserve can change the money
supply on a daily basis through open market
operations. Thus, once the Open Market
Committee decides on a particular policy, the
policy can be implemented immediately.
However, monetary policy works through
changes in interest rates and the response of
interest-sensitive components of AD to the
interest rate changes. The response of
investment and consumption takes time.
7.
Explain why the outside lag is short for
fiscal policy.
The outside lag is short for fiscal policy for
several reasons:
(1) Fiscal policy has been debated in Congress
and discussed extensively in the media. Thus,
as soon as it is enacted, people can respond.
(2) If the fiscal policy is a tax change, the
effects will be within a year’s time.
(3) If the fiscal policy is an expenditure
change, the effect will be felt almost
immediately as the affected agency changes its
spending pattern.
8.
Explain why lags are important to the
discussion of stabilization policy.
The existence of policy lags implies that policy actions could be
out of sequence with the economy. For example, expansionary
policy might have its impact after the economy has started to
recover from a recession. As a result, the expansionary policy
may create inflation because it over stimulates the economy. This
problem has led some economies to recommend policy rules.
Examples of policy rules are that money supply should grow at
5% a year and nominal GDP should grow at 6% a year. There’s a
second reason why understanding lags is important for
stabilization policy. Policy makers should not think that policy can
fine-tune the economy at any point in time.
Crowding-Out: A Graphical
Representation
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Sources of government borrowing:
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Treasury Bills
Treasury Notes
Treasury Bonds
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Government’s demand for funds increases
the demand for money.
Interest
Rate
MS
i1
i
MD1
MD
Money
Fig. 44.1: Crowding-Out Using AD and AS Analysis
Nominal
Interest
Rate
PL
MS
SRAS
p
i
MD
AD
Y*
Real GDP
Quantity
of Money
1. Assume fiscal policy is expansionary and monetary policy
keeps the stock of money constant at MS. Shift one curve in
each graph to illustrate the effect of the fiscal policy.
Nominal
Interest
Rate
PL
MS
SRAS
p1
p
AD1
i
MD
AD
Y*
A.
Y1
Real GDP
Quantity of Money
Which curve did you shift in the short-run AD and AS
supply graph? What happens as a result of this new
curve?
Shift the AD curve to AD1, as a result of the
expansionary fiscal policy. The PL and Y both
increase
Nominal
Interest
Rate
PL
MS
SRAS
p1
i1
p
AD1
MD1
MD
AD
Y*
B.
Y1
i
Real GDP
Quantity
of Money
In the money market graph, which curve did you shift
to demonstrate the effect of the fiscal policy? What
happens as a result of this shift?
Shift the MD curve to the right; money demand
increased because real GDP increased. Interest
rate rises.
Nominal
Interest
Rate
PL
MS
SRAS
p1
p2
p
AD1
AD2
i1
i
MD1
MD
AD
Y* Y2 Y1
C.
Real GDP
Quantity
of Money
Given the change in interest rates, what happens in
the short-run AS and AD graph?
AD shifts back to AD2 because the increase in
interest rates reduces some private domestic
investment and interest-sensitive consumer
spending. This is crowding-out.
Nominal
Interest
Rate
PL
MS MS1
SRAS
p1
p2
p
AD1
AD2
AD
Y* Y2 Y1
D.
Real GDP
i1
i
MD1
MD
Quantity
of Money
How could a monetary policy action prevent the changes in interest rates and
output you identified in (B) and (C)? Shift a curve in the money market graph, and
explain how this shift would reduce crowding-out.
Shift the money supply curve to MS1. If the money supply is
increased to MS1, interest rates would move back to i. If interest
rates are at i, there would be no crowding-out (or reduction) of
investment spending, and the AD would be AD1.
Loanable Funds Market
Interest
Rate
S
i1
i
D + (G – T)
Note: The original
demand curve is for the
private sector ONLY. At
the beginning there is
no borrowing or debt by
the federal government.
The increase in
government demand for
funds crowds-out
private investment.
D
I2
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I
I1
Quantity of Loanable Funds
I and i are the initial equilibrium values.
D = private sector demand for funds (Investment)
D + (G–T) = private + government demand for funds
I1 and i1 are the new equilibrium values.
I2 = new level of private investment
I1 – I2 = government demand for funds (G – T)
Interest
Rate
S
i1
i
D + (G – T)
D
I2
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I
I1
Quantity of Loanable Funds
I2 is the quantity of loanable funds demanded by
the new equilibrium because at i1 (the
equilibrium interest rate), I2 is the quantity of
investment funds the private sector demands, as
shown by the private-sector demand curve.
Barro-Ricardo Effect
According to Barro-Ricardo effect budget deficit has no
effect on the real interest rate or investment. This means
that financing government purchases by taxes or by
borrowing is equivalent.
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Interest
Rate
S
i1
i
D + (G – T)
D
I2
I
I1
Quantity of Loanable Funds
Barro-Ricardo Effect
The supply curve for funds will shift rightward. The
rightward shift in the supply curve reduces the increase
in the interest rate and reduces the decrease in the
private sector demand for funds. Thus, the crowdingout effect is reduced if there is a Barro-Ricardo effect.
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Interest
Rate
S
i1
i
D + (G – T)
D
I2
I
I1
Quantity of Loanable Funds
Barro-Ricardo Effect
There is little evidence that the Barro-Ricardo effects
very large.
However, crowding-out can be significant, depending on
the elasticity of investment and interest-sensitive
components of AD.
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Interest
Rate
S
i1
i
D + (G – T)
D
I2
I
I1
Quantity of Loanable Funds
Part B: Using the Loanable Funds Market
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The loanable funds market provides another
approach to looking at the effects of increases in
the budget deficit.
The demand for funds in the loanable funds
market comes from the private sector (business
investment and consumer borrowing), the
government sector (budget deficits) and the
foreign sector.
The supply of funds in the loanable funds
market comes from private savings (businesses
and households), the government sector
(budget surpluses), the Federal Reserve (money
supply) and the foreign sector.
Fig. 44.2: Loanable Funds Market
S
Interest
Rate
i1
i
D1
D
Quantity of Loanable Funds
2.
Shift one of the curves on Fig 44.2 to indicate what
occurs in the loanable funds market if government
spending increases without any increases in tax
revenue or the money supply.
The demand increases, shifting the demand
curve to D1. D1 represents the private plus
public demand for loanable funds.
Fig. 44.2: Loanable Funds Market
S
Interest
Rate
i1
i
D1
D
Quantity of Loanable Funds
A.
What happens to the interest rate as a result of
this expansionary fiscal policy? Explain.
There is an increase in the demand for loanable
funds to pay for the increased government
spending. The interest rate rises to i1
Fig. 44.2: Loanable Funds Market
S
Interest
Rate
i1
i
D1
D
Q
B.
Quantity of Loanable Funds
Indicate on the graph the new quantity
of private demand for loanable funds.
At the higher interest rate (i1), the level of
private demand for loanable funds is Q
S
Interest
Rate
S1
i1
i
D1
D
Q
Quantity of Loanable Funds
C. An accommodating monetary policy could prevent the effects you described
in (A) and (B). Shift a curve in the diagram to show how the
accommodating monetary policy would counteract the effects of crowdingout. Explain what would happen to interest rates and the level of private
demand for loanable funds as a result of this new curve.
If the monetary authorities expanded the money supply to keep interest
rates constant at the original level, a larger quantity of loanable funds
would be available, and there would be no crowding-out. The new
supply curve in S1, interest rates return to i and the private sector
receives the original level of loanable funds.
Part C: Applications
3.
Indicate whether you agree (A), disagree (D) or are
uncertain (U) about the truth of the following
statement and explain your reasoning. “Exhaustion
of excess bank reserves inevitably puts a ceiling on
every business boom because without money the
boom cannot continue.”
Uncertain. The answer should depend on the
assumptions that are made. The boom could continue
to grow if the velocity of circulation increases.
Increased demand for a fixed money stock would tend
to increase interest rates, and increased velocity is
associated with higher interest rates. However, the
higher interest rates could cause investment to
decrease and slow economic growth.
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4.
Answer the questions that follow each of
the scenarios below.
The Federal Reserve Open Market
Committee wishes to accommodate or
reinforce a contractionary fiscal policy.
A.
B.
Would the Fed buy bonds, sell bonds or
neither? Sell bonds.
What effect would this policy have on bond
prices and interest rates?
Bond prices would decrease, and the interest
rate would increase.
C.
What effect would this policy have on
bank reserves and the money supply?
Bank reserves would decrease, and the
money supply would decrease.
D.
What effect would this policy have on
the quantity of loanable funds demanded
by the private sector?
The bond sale would decrease the supply of
loanable funds; the increase in the interest
rate would decrease the quantity
demanded of loanable funds (movement
along the demand curve).
E.
What effect would the change in interest
rates you identified in (B) have on
aggregate demand?
AD would decrease because the
higher interest rates would curtail
the interest-sensitive components
of consumption and investment.
5.
A.
B.
The Federal Reserve Open Market
Committee wishes to accommodate or
reinforce an expansionary fiscal policy.
Would the Fed buy bonds, sell bonds or
neither? Buy bonds.
What effect would this policy have on
bond prices and interest rates?
The price of bonds would increase,
and the interest rate would
decrease.
C.
What effect would this policy have on
bank reserves and the money supply?
Bank Reserves would increase and
the money supply would increase.
D.
What effect would this policy have on
the quantity of loanable funds demanded
by the private sector?
The quantity demanded of loanable
funds would increase.
E.
What effect would the change in interest
rates you identified in (B) have on AD?
AD would increase because of the
lower interest rates and the
resulting increase in interestsensitive components of
consumption and investment.