2. Objectives Explain inside and outside lags for monetary and fiscal policy. Define the crowding-out Explain the effects of crowding-out within the shortrun AD and AS model. Demonstrate the use of monetary policy to lessen or reinforce the crowding-out effect. 3. 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. 4. 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 governments 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. 5. 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. 6. 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). 7. Monetary Policy 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 requirementInflationReal OutputIncreaseIncreaseDecreaseDecreaseIncreaseIncreaseDecreaseDecreaseIncreaseIncreaseDecreaseDecrease 8. Fiscal PolicyInflationReal OutputIncreaseIncreaseDecreaseDecreaseDecreaseDecreaseIncreaseIncrease4. (A) Increase government spending (B) Decrease government spending 5. (A) Increase taxes (B) Decrease taxes 9. 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. 10. Crowding-Out: A Graphical Representation Sources of government borrowing: Treasury Bills Treasury Notes Treasury Bonds 11. Governments demand for funds increases the demand for money. Interest RateMS i1iMD1 MDMoney 12. Crowding-Out Using AD and AS Analysis Nominal Interest RatePLMS SRASp i MDAD Y*Real GDPQuantity of Money1. 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. 13. Nominal Interest RatePLMS SRAS p1 p AD1i MDAD Y*A.Y1Real GDPQuantity of MoneyWhat happens as a result of this new curve?Shift the AD curve to AD1, as a result of the expansionary fiscal policy. The Price Levels and Y both increase 14. Nominal Interest RatePLMS SRAS p1i1 p AD1MD1 MDAD Y*Y1iReal GDPQuantity of MoneyB. 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? Shift the MD curve to the right; money demand increased because real GDP increased. Interest rate rises. 15. Nominal Interest RatePLMS SRAS p1i1p2 pAD1 AD2MD1 MDAD Y* Y2C.Y1iReal GDPQuantity of MoneyGiven 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 interestsensitive consumer spending. This is crowding-out. 16. Nominal Interest RatePLMSMS1SRAS p1i1p2 pAD1 AD2MD1 MDAD Y* Y2 D.Y1iReal GDPQuantity of MoneyHow 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. 17. 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? Sell bondsA. What effect would this policy have on bond prices and interest rates? Bond prices would decrease, and the interest rate would increase. 18. 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). 19. 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 interestsensitive components of consumption and investment. 20. 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? Buy bonds. B. What effect would this policy have on bond prices and interest rates? The price of bonds would increase, and the interest rate would decrease. 21. 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. 22. 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.