Consider an increase in government spending. Explain the eect on the interest rate and output of an economy in which (a) (5 points) The Central Bank chooses the quantity of money. (b) (5 points) The Central Bank follows an interest rate rule. Is the change in output larger, smaller or equal than in (a)? Why?

Consider an increase in government spending. Explain the eect on the interest rate and output of an economy in which

(a) (5 points) The Central Bank chooses the quantity of money.

(b) (5 points) The Central Bank follows an interest rate rule. Is the change in output larger, smaller or equal than in (a)? Why?

 

 

Answer:

Consider an increase in government spending. Explain the effect on the interest rate and output of an economy in which

(a) If the central bank responds to increased government spending by increasing the money supply i.e. printing more money in the way of deficit financing, the interest rate will go high and output of the economy may go down because of the crowding out effect. When the government spends more, it demands more of loanable funds. However, the total amount of loanable funds in an economy is contestant in the short-run. Therefore, increase in demand for loanable fund by the government increases the price i.e. interest rate of loanable funds. According to the estimates of Laubach’s, with 1% increase in the deficit to GDP ratio, long-term interest rates increase by around 0.25%.

Now, when the interest rate is high, the private businesses may not want to take loans from banks as this would increase their cost of capital. Therefore, private businesses may hold their expansion plans or projects, or they may reduce investment, which can reduce the level of output in the economy. Also, with the increase in interest rate, the Marginal Propensity to Consume (MPC) is lower than the Marginal Propensity to Save (MPS), which encourages consumers to save more and earn high interest on saving rather than spend. Therefore, consumer demand also goes down, which in turn may put downward pressure on output level.

(b) However, if the central bank keeps the interest rate low, private business firms will be able to borrow more and expand their capacity to produce more, which in turn increase the supply of goods and services and increase output level. Also, low interest rate will encourage consumers to save less and spend more as they will now earn less from their bank-deposits and they will be able to borrow money at a lower cost.

Asked on February 15, 2018 in economics.
Add Comment
0 Answer(s)
  • Votes
  • Oldest

Your Answer

By posting your answer, you agree to the privacy policy and terms of service.