Question

An expansionary fiscal policy increases National income (GDP). The result is an increase in Money Demand by 100. Suggest and show a Monetary Policy action to prevent Crowding Out caused by the Fiscal Policy action. Consider the Required Reserves is .125

Answer 1

Due to the expansionary fiscal policy we know that the interest rates rises and the government runs to deficit and hence to avoid this there must be an expansionary monetary policy like increasing money supply which will lead in stabilising the interest rates and also allowing the government to meet its deficit. This will nullify the crowding out effect.

So, When Expansionary fiscal policy increase money demand by 100 then there must be an equal amount of money in the economy to meet it. So Effective increase in Money supply should be also be 100.

As, Required Reserve ratio (RR) = 0.125

We know, Money Multiplier = 1/RR = 1/0.125 = 8

Let the increase in money supply by expansionary monetary policy = M

As, Effective increase in money supply = 100

So, M * Money Multiplier = 100

M * 8 = 100

M = 100/8 = 12.5

So, Monetary policy action to avoid crowding out effect is by expansionary monetary policy which must increase the money supply by 12.5