Policy Lags and Crowding-Out Effect

Objectives• Explain inside and outside lags for monetary and

fiscal policy.• Define the crowding-out • Explain the effects of crowding-out within the short-

run AD and AS model.• Demonstrate the use of monetary policy to lessen or

reinforce the crowding-out effect.

Introduction• Here, we discuss the lags associated with monetary

and fiscal policy making and analyze 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.

• 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:– The demand by government for loanable funds

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

Lags Associated With Policy Making

• 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.

Monetary and Fiscal Policy

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).

1. (A) Buy government securities    

(B) Sell government securities    

2. (A) Decrease the repo rate    

(B) Increase the repo 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

Lags in Policy Making

• 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.

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

Crowding-Out: A Graphical Representation

• Sources of government borrowing:– Treasury Bills– Treasury Notes– Treasury Bonds

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

Interest Rate

Money

i

i1

MD

MD1

MS

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. What happens as a result of this new curve?

Nominal Interest Rate

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 Price Levels and Y both increase

AD1

Y1

p1

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

Nominal Interest Rate

PL

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

Nominal Interest Rate

PL

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. 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.

Nominal Interest Rate

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

Applications:Answer the questions that follow each of the scenarios below.1. The RBI Open Market Committee wishes to

accommodate or reinforce a contractionary fiscal policy.

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

B. What effect would this policy have on bond prices and interest rates?Bond prices would decrease, and the interest rate would increase.

Sell bonds

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

D. What effect would this policy have on the quantity of loanable funds 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. 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.

2. The RBI Open Market Committee wishes to accommodate or reinforce an expansionary fiscal policy.

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

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

Buy bonds.

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?

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

Bank Reserves would increase and the money supply would increase.

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 interest-sensitive components of consumption and investment.