A Question for My ECON201 Buddies... (1 Viewer)

[Luke!]

I was goin' through the exam practice questions...

(10) For this question, assume that the economy is initially operating at the natural level of output. A simultaneous increase in government spending and reduction in the price target by the central bank will cause which of the following?

A) an increase in output and an increase in the aggregate price level in the short run
B) a reduction in output and an increase in the nominal wage in the short run
C) a reduction in investment in the medium run
D) a reduction in the interest rate in the medium run
E) an increase in the aggregate price level, no change in output, and no change in the interest rate in the medium run


Alright, I'm thinking it is C. Increased government spending should crowd out investment in the medium run, right?

I figure it can't be A or B 'cuz the effect of expansionary fiscal policy plus contractionary monetary policy on output is ambiguous.

And I think it can't be D 'cuz of the 'neutrality of monetary policy in the medium run' proposition.

As for E, contractionary monetary policy should lead to a decrease in the aggregate price level, right?

So am I right?

 

[Luke!]

Alright, the answers are out on WebCT. I was right... it was C. Go me!

 

[jake2.0]

Could you possibly explain what you mean by "Increased government spending should crowd out investment in the medium run, right?"

 

[Luke!]

In section 7.5 of your ECON201 textbook it shows the IS relation in terms of the natural level of output... I'll try to explain it as best I can...

Yn = C0 + C1(Yn-T) + I(Yn,i) + G

So if C0, C1 and T remain the same, while if Yn is also to remain the same... then as government spending increases, something else must decrease in order to keep the above equation correct.

So what decreases? The only thing we have left that doesn' t stay constant— Investment, and it does so over the medium run.

I'll summarise it like this: As G increases, the AD curve is right-shifted, so output rises to Y' > Yn, thus over the medium run wage setters increase their price level expectations, Pe... thus wages, W, increase and this also causes the price level, P, to increase... thus the AS curve begins to shift upwards.

The only problem is the Central Bank hasn't changed it's price target, PT... so somehow the economy has to make it back to equilibrium so that the price level is still the same... and this happens when the central bank increases i(n) in it's interest rate rule: i = i(n) + a(P-PT). (And it does this when it realises the permanence of the increase in government spending.)

This increase in i(n) causes the economy to move back to the exact same equilibrium it was in before the increase in government spending— that is, the AS-AD curves will be in the same spot as they originally were, just at a higher interest rate, and thus at a lower level of investment.

So in the medium run the increase in Government Spending is exactly offset by the decrease in Investment, thus one 'crowds out' the other. It works in reverse too, a decrease in G causes a medium run increase in I.

Expansionary Fiscal Policy = A decrease in investment in the medium/long run.
Contractionary Fiscal Policy = An increase in investment in the medium/long run.

As a side note, Monetary Policy has no effect on output, interest rates or money supply in the medium/long run— this is the 'neutrality of money' proposition. (Refer to section 7.4 in the textbook.)