Policy Lags and Crowding-Out Effect

Policy Lags and Policy Lags and Crowding-Out Effect Crowding-Out Effect

Unit 5 Lesson 1Unit 5 Lesson 1Activities 43 & 44Activities 43 & 44

Goodman, Rae Jean B.. U.S. Naval AcademyGoodman, Rae Jean B.. U.S. Naval AcademyAdvanced Placement Economics Teacher Resource Advanced Placement Economics Teacher Resource ManualManual. National Council on Economic Education, . National Council on Economic Education,

New York, N.YNew York, N.Y

ObjectivesObjectives Explain inside and outside lags for Explain inside and outside lags for

monetary and fiscal policy.monetary and fiscal policy. Define the crowding-out and the Barro-Define the crowding-out and the Barro-

Ricardo effect.Ricardo effect. Explain the effects of crowding-out within Explain the effects of crowding-out within

the short-run AD and AS model.the short-run AD and AS model. Explain how the Barro-Ricardo effect can Explain how the Barro-Ricardo effect can

reduce the crowing-out effect while reduce the crowing-out effect while simultaneously reducing the effects of the simultaneously reducing the effects of the fiscal policy.fiscal policy.

Demonstrate the use of monetary policy to Demonstrate the use of monetary policy to lessen or reinforce the crowding-out effect.lessen or reinforce the crowding-out effect.

IntroductionIntroduction This lesson discusses the lags associated This lesson discusses the lags associated

with monetary and fiscal policy making with monetary and fiscal policy making and analyzes the direct and indirect and analyzes the direct and indirect effects of government budget deficits.effects of government budget deficits.

The direct effect of these deficits is an The direct effect of these deficits is an increase in interest rates.increase in interest rates.

When the government borrows money to When the government borrows money to finance its deficit, this results in an finance its deficit, this results in an increase in the demand for money, or, increase in the demand for money, or, alternatively, the demand for loanable alternatively, the demand for loanable funds. This in turn results in an increase in funds. This in turn results in an increase in the interest rate.the interest rate.

A higher interest rate causes A higher interest rate causes decreases in investment and other decreases in investment and other interest sensitive components of AD.interest sensitive components of AD.

Crowding-out is the decrease in Crowding-out is the decrease in private demand for funds that occurs private demand for funds that occurs when the government’s demand for when the government’s demand for funds causes the interest rate to rise:funds causes the interest rate to rise: The demand by government for loanable The demand by government for loanable

funds decreases or funds decreases or crowds-out crowds-out the the private demand for loanable funds.private demand for loanable funds.

Lags Associated With Policy MakingLags Associated With Policy Making

The The inside laginside lag consists of the time it consists of the time it takes for data to be collected, policy takes for data to be collected, policy makers to recognize that policy makers to recognize that policy action is necessary, the decision action is necessary, the decision about which policy should be taken about which policy should be taken and the implementation of the policy.and the implementation of the policy.

The The outside lagoutside lag is the time it takes is the time it takes the economy to respond to the new the economy to respond to the new policy. These lags differ in length for policy. These lags differ in length for monetary policy and fiscal policy.monetary policy and fiscal policy.

Activity 43: Monetary and Fiscal PolicyActivity 43: Monetary and Fiscal Policy

Part A: Tools of Monetary and Fiscal Part A: Tools of Monetary and Fiscal PolicyPolicy

Both monetary and fiscal policy can Both monetary and fiscal policy can be used to influence the inflation rate be used to influence the inflation rate and real output. Indicate what effect and real output. Indicate what effect each specific policy has on inflation each specific policy has on inflation and real output in the short-run (9 to and real output in the short-run (9 to 18 months).18 months).

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

Monetary Policy Inflation Real Output

Increase Increase

Decrease

Decrease

Increase Increase

Decrease

Decrease

Increase Increase

Decrease

Decrease

Fiscal PolicyInflation Real Output

4. (A) Increase government spending

(B) Decrease government spending

5. (A) Increase taxes

(B) Decrease taxes

Increase Increase

Decrease

Decrease

Decrease

Decrease

Increase Increase

Part B: Lags in Policy MakingPart B: Lags in Policy Making

As the economic situation changes, As the economic situation changes, policy makers must decide when to take policy makers must decide when to take action and what policy action to take. action and what policy action to take. Then they must implement the policy. Then they must implement the policy.

The economy then responds to the The economy then responds to the policy. The amount of time it takes policy. The amount of time it takes policy makers to recognize and take policy makers to recognize and take action is called action is called inside-lags.inside-lags.

The amount of time it takes the The amount of time it takes the economy to respond to the policy economy to respond to the policy changes is called changes is called outside or impact lags.outside or impact lags.

The inside lag is estimated to be The inside lag is estimated to be short for monetary policy, but long short for monetary policy, but long for fiscal policy. for fiscal policy. The inside lag is long for fiscal policy The inside lag is long for fiscal policy

because the legislative branch must because the legislative branch must come to agreement about the come to agreement about the appropriate action.appropriate action.

The outside lag, however, is long and The outside lag, however, is long and variable for monetary policy but very variable for monetary policy but very short for the fiscal policy.short for the fiscal policy.

6.6. Explain why the inside lag can be Explain why the inside lag can be short for monetary policy, but the short for monetary policy, but the outside lag is long and variable.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.

7.7. Explain why the outside lag is short Explain why the outside lag is short for fiscal policy.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.

8.8. Explain why lags are important to the Explain why lags are important to the discussion of stabilization policy.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 Crowding-Out: A Graphical RepresentationRepresentation

Sources of government borrowing:Sources of government borrowing: Treasury BillsTreasury Bills Treasury NotesTreasury Notes Treasury BondsTreasury Bonds

Government’s demand for funds Government’s demand for funds increases the demand for money.increases the demand for money.

Interest Rate

Money

i

i1

MD

MD1

MS

Fig. 44.1: Crowding-Out Using AD and AS AnalysisFig. 44.1: Crowding-Out Using AD and AS Analysis

Nominal Interest Rate

Quantity of Money

i

MD

MS

PL

Real GDP

AD

p

Y*

SRAS

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.

A.A. Which curve did you shift in the short-run AD Which curve did you shift in the short-run AD and AS supply graph? What happens as a result and AS supply graph? What happens as a result of this new curve? of this new curve?


Quantity of Money

i

MS

PL

Real GDP

AD

p

Y*

SRAS

MD

Shift the AD curve to AD1, as a result of the expansionary fiscal policy. The PL and Y both increase

AD1

Y1

p1

B.B. In the money market graph, which curve did you In the money market graph, which curve did you shift to demonstrate the effect of the fiscal shift to demonstrate the effect of the fiscal policy? What happens as a result of this shift?policy? What happens as a result of this shift?

Nominal Interest RatePL

Real GDP

AD

p

Y*

SRAS

AD1

Shift the MD curve to the right; money demand increased because real GDP increased. Interest rate rises.

Y1

p1

i

i1

MS

MD1

MD

Quantity of Money

C.C. Given the change in interest rates, what Given the change in interest rates, what happens in the short-run AS and AD graph?happens in the short-run AS and AD graph?

Nominal Interest RatePL

Real GDP

AD

p

Y*

SRAS

AD1

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.

AD2

Y1Y2

p1

p2

i

i1

MS

MD1

MD

Quantity of Money

D.D. How could a monetary policy action prevent the changes in interest 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 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-money market graph, and explain how this shift would reduce crowding-out.out.


i

i1

MS

PL

Real GDP

AD

p

Y*

SRAS

MD1

MD

AD1

AD2

Y1Y2

p1

p2

Quantity of Money

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.

MS1

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)

Loanable Funds MarketInterest Rate

Quantity of Loanable Funds

S

D

D + (G – T)i

i1

I I1I2

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.

II22 is the quantity of loanable funds demanded is the quantity of loanable funds demanded by the new equilibrium because at iby the new equilibrium because at i11 (the (the equilibrium interest rate), Iequilibrium interest rate), I22 is the quantity of is the quantity of investment funds the private sector demands, investment funds the private sector demands, as shown by the private-sector demand curve.as shown by the private-sector demand curve.

Interest Rate


S

D

D + (G – T)i

i1

I I1I2

Barro-Ricardo EffectBarro-Ricardo Effect According to Barro-Ricardo effect budget deficit According to Barro-Ricardo effect budget deficit

has no effect on the real interest rate or has no effect on the real interest rate or investment. This means that financing investment. This means that financing government purchases by taxes or by borrowing government purchases by taxes or by borrowing is equivalent.is equivalent.

Interest Rate


S

D

D + (G – T)i

i1

I I1I2

Barro-Ricardo EffectBarro-Ricardo Effect The supply curve for funds will shift rightward. The supply curve for funds will shift rightward.

The rightward shift in the supply curve reduces The rightward shift in the supply curve reduces the increase in the interest rate and reduces the the increase in the interest rate and reduces the decrease in the private sector demand for funds. decrease in the private sector demand for funds. Thus, the crowding-out effect is reduced if there Thus, the crowding-out effect is reduced if there is a Barro-Ricardo effect.is a Barro-Ricardo effect.

Interest Rate


S

D

D + (G – T)i

i1

I I1I2

Barro-Ricardo EffectBarro-Ricardo Effect There is little evidence that the Barro-Ricardo There is little evidence that the Barro-Ricardo

effects very large. effects very large. However, crowding-out can be significant, However, crowding-out can be significant,

depending on the elasticity of investment and depending on the elasticity of investment and interest-sensitive components of AD.interest-sensitive components of AD.

Interest Rate


S

D

D + (G – T)i

i1

I I1I2

Part B: Using the Loanable Funds MarketPart B: Using the Loanable Funds Market

The loanable funds market provides The loanable funds market provides another approach to looking at the effects another approach to looking at the effects of increases in the budget deficit. of increases in the budget deficit.

The The demand demand for funds in the loanable for funds in the loanable funds market comes from the private funds market comes from the private sector (business investment and consumer sector (business investment and consumer borrowing), the government sector borrowing), the government sector (budget deficits) and the foreign sector. (budget deficits) and the foreign sector.

The The supplysupply of funds in the loanable funds of funds in the loanable funds market comes from private savings market comes from private savings (businesses and households), the (businesses and households), the government sector (budget surpluses), the government sector (budget surpluses), the Federal Reserve (money supply) and the Federal Reserve (money supply) and the foreign sector.foreign sector.

Fig. 44.2: Loanable Funds MarketFig. 44.2: Loanable Funds Market

2.2. Shift one of the curves on Fig 44.2 to indicate Shift one of the curves on Fig 44.2 to indicate what occurs in the loanable funds market if what occurs in the loanable funds market if government spending increases without any government spending increases without any increases in tax revenue or the money supply.increases in tax revenue or the money supply.

Interest Rate


S

D

i

i1

The demand increases, shifting the demand curve to D1. D1 represents the private plus public demand for loanable funds.

D1


A.A. What happens to the interest rate as a result What happens to the interest rate as a result of this expansionary fiscal policy? Explain.of this expansionary fiscal policy? Explain.

Interest Rate


S

D

i

i1

There is an increase in the demand for loanable funds to pay for the increased government spending. The interest rate rises to i1

D1


B.B. Indicate on the graph the new quantity Indicate on the graph the new quantity of private demand for loanable funds.of private demand for loanable funds.

Interest Rate


S

D

i

i1

At the higher interest rate (i1), the level of private demand for loanable funds is Q

D1

Q

C. An accommodating monetary policy could prevent the effects you C. An accommodating monetary policy could prevent the effects you described in (A) and (B). Shift a curve in the diagram to show described in (A) and (B). Shift a curve in the diagram to show how the accommodating monetary policy would counteract the how the accommodating monetary policy would counteract the effects of crowding-out. Explain what would happen to interest effects of crowding-out. Explain what would happen to interest rates and the level of private demand for loanable funds as a rates and the level of private demand for loanable funds as a result of this new curve.result of this new curve.

Interest Rate


S

D

i

i1

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.

D1

Q

S1

Part C: ApplicationsPart C: Applications

3.3. Indicate whether you agree (A), disagree (D) Indicate whether you agree (A), disagree (D) or are uncertain (U) about the truth of the or are uncertain (U) about the truth of the following statement and explain your following statement and explain your reasoning. “Exhaustion of excess bank reasoning. “Exhaustion of excess bank reserves inevitably puts a ceiling on every reserves inevitably puts a ceiling on every business boom because without money the business boom because without money the boom cannot continue.”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.

Answer the questions that follow Answer the questions that follow each of the scenarios below.each of the scenarios below.

4.4. The Federal Reserve Open Market The Federal Reserve Open Market Committee wishes to accommodate Committee wishes to accommodate or reinforce a contractionary fiscal or reinforce a contractionary fiscal policy.policy.

A.A. Would the Fed buy bonds, sell bonds or Would the Fed buy bonds, sell bonds or neither?neither?

B.B. What effect would this policy have on What effect would this policy have on bond prices and interest rates?bond prices and interest rates?

Sell bonds.

Bond prices would decrease, and the interest rate would increase.

C.C. What effect would this policy have What effect would this policy have on bank reserves and the money on bank reserves and the money supply?supply?

D.D. What effect would this policy have What effect would this policy have on the quantity of loanable funds on the quantity of loanable funds demanded by the private sector?demanded by the private sector?

Bank reserves would decrease, and the money supply would decrease.

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.E. What effect would the change in What effect would the change in interest rates you identified in (B) interest rates you identified in (B) have on aggregate demand?have on aggregate demand?

AD would decrease because the higher interest rates would curtail the interest-sensitive components of consumption and investment.

5.5. The Federal Reserve Open Market The Federal Reserve Open Market Committee wishes to accommodate Committee wishes to accommodate or reinforce an expansionary fiscal or reinforce an expansionary fiscal policy.policy.

A.A. Would the Fed buy bonds, sell Would the Fed buy bonds, sell bonds or neither?bonds or neither?

B.B. What effect would this policy have What effect would this policy have on bond prices and interest rates?on bond prices and interest rates?

Buy bonds.

The price of bonds would increase, and the interest rate would decrease.

C.C. What effect would this policy have What effect would this policy have on bank reserves and the money on bank reserves and the money supply?supply?

D.D. What effect would this policy have What effect would this policy have on the quantity of loanable funds on the quantity of loanable funds demanded by the private sector?demanded by the private sector?

Bank Reserves would increase and the money supply would increase.

The quantity demanded of loanable funds would increase.

E.E. What effect would the change in What effect would the change in interest rates you identified in (B) interest rates you identified in (B) have on AD?have on AD?AD would increase because of the lower interest rates and the resulting increase in interest-sensitive components of consumption and investment.

Documents

Policy Lags and Crowding-Out Effect