Question

2. The economy is in a recession. The government increases spending in an effort to move the economy toward full employment (Y*). Money demand is interest sensitive and investment is interest insensitive.

a. How much crowding out would you expect relative to monetary policy;

b. what sectors of the economy are impacted and why,

c. explain each step of the adjustment process,

d. graph the process (show both “the crowing out” and the path –process– the economy will follow).

Answer 1

Money demand is interest sensitive meaning a small change in interest rate will lead to a large change in money demand, so LM curve is relatively flatter. Investment is interest insensitive meaning a large change in interest rate will lead to a smaller change in investment demand, so IS curve is relatively steeper.

a) IS equation: Y = C+I+G+NX There will be relatively less crowding out because IS is steep i.e investment is interest insensitive. So when government increases spending, investment doesn't fall as much (in response to the increase in interest rate) as it would have if it had been more sensitive to interest rate. Hence, increase in income is more than the increase in interest rate.

b) Crowding out affects the industrial/ infrastructure/ business sectors because they undertake large scale investments and finance their investments through borrowing. So when interest rate rises as a result of increased govt spending, the cost of borrowing for the firms increases and so their investment falls.  

c) Economy is originally at Y and i, with equilibrium at e. When govt increases spending, AD increases, so IS shifts to the right. There is more demand so firms supply more output so Y increases to Y' . Increase in Y makes people demand more money, so the economy moves upwards along the LM curve( see arrows). Since money supply is fixed, interest rate has to rise to so that demand for money falls to equal the money supply. So, i increases to i'. New equilibrium is reached at e'.