Fiscal Policy in a Liquidity Trap - Assignment Example

Running Head: Advanced Macroeconomics Advanced Macroeconomics Student’s Name College Instructor’s Name Course Name: Question 1: Fiscal policy in a liquidity trap Fiscal policy is the government’s attempt to influence aggregate demand in the economy by regulating the amount of public expenditure and the rates of taxation. This policy is made more flexible by the fact that governments do not need to keep ‘balanced budgets’-they can run a budget surplus by spending less than they raise in taxes. Under normal circumstances change in government spending causes income to rise and this, in turn, causes the transactions demand for money to increase; with a constant money stock, less is now is now available for speculative purposes, so that interest rates are pushed upwards and this causes private investment to be cut back, so offsetting to some extent the effect of the increase in government spending on income. However, it is possible it is possible for fiscal policy to be completely ineffective so far as its influence over equilibrium national income is concerned. This when the level of income remains unchanged whichever fiscal policy is applied. This is point of liquidity trap. In liquidity trap, interest rates are unaffected by fiscal policy, but income rises by the full multiplier effect. Figure 1: Fiscal policy completely ineffective figure 2: Fiscal policy very effective From the two graphs above, the effectiveness of fiscal policy is shown by the steepness of the IS curve. The policy would be completely ineffective if the IS curve were horizontal, but would have its full effect if it were vertical. The steepness of the IS curve depends largely on the interest-elasticity of investment completely interest-elastic investment yields a horizontal IS curve, as shown in figure 1; increased government expenditure leaves the IS curve unchanged so that the policy has no effect on income. Perfectly interest-inelastic investment would yield a vertical IS curve, as shown in figure 2 and, in this case, an increase in government expenditure would have a full multiplier effect. Y Figure 3: Fiscal policy completely ineffective figure 4: Fiscal policy very effective Generally, any increase in the spending made by the government authorities needs to be financed through other sources. Issuance of bonds or mere printing of new money to finance the expenditure will result in deficits of the government to the private parties. One policy, which is used often, is any increase in government spending is harmonized by an equal increase in government’s tax collection so as to keep the government’s budget incrementally balanced. Here, the government incurs no additional indebtedness. Given this equal increases in government expenditure and taxes, the change in the national income due to a change in government expenditure is referred as the balanced budget multiplier in macroeconomics. For deriving the balanced budget multiplier, one may consider the following national income identity So, the value of the balanced budget multiplier is unity. A multiplier of one implies that output expands precisely by the increase in government expenditure with no induced consumption spending. Here, the effect of higher taxes is exactly offset the effect of the income expansion. Consequently, disposable income, and consumption remain constant. Government expenditure is harmonized by an equal increase in government’s borrowings so as to keep the government’s budget incrementally balanced. Here, the government incurs additional indebtedness. Given this equal increases in government expenditure and borrowings, the change in the national income due to a change in government expenditure is referred as the balanced budget multiplier in macroeconomics. As government expenditure is matched by an equal increase in interest rates, the value of the balanced budget multiplier is unity. Therefore, MP curve is positively sloped and its curvature depends upon the income sensitivity and the interest rate sensitivities of the demand for money. If there is an increase in the autonomous an increase in government spending IS curve shifts upwards and vice versa. Question 2: Nominal GDP targeting with rational expectations Let us assume that a target for the growth rate of nominal GDP is , From the equation is actual growth rate of nominal GDP while is target growth rate of nominal GDP, is the natural log of nominal GDP, and where the stochastic white noise variable assuming that , and p as well as y are the logs of the price level and of real output. Let us look at the supply side of AS-curve: Then This result cannot be guaranteed, however, once we allow the price level to vary. In the more general AD-AS model, the effect of an increase in aggregate demand on real income depends on the shape of the AS curve. Putting it simply: only if the AS curve is horizontal will the effect be entirely on real income; if the AS curve is upward sloping but fairly flat, the effect will be mainly on real income, with just a small rise in the price level; if the AS curve is steep, the effect will be entirely on the price level. The real output and inflation on the assumption that expectations are rational as shown above indicates change in policy will attract depicts that the Policy Ineffectiveness Proposition hold in this model. Consequently, new equilibriums are set up at B and B. Monetarists argue that inflation develops initially if the money supply is expanded faster than the economy’s long-run growth of productive capacity. But once inflation is under way, it develops a momentum of its own because people expect further inflation and incorporate there expectations is their price fixing and wage demands. The duration and amount of unemployment above the ‘natural’ rate that is required to reduce the rate off inflation depends on the length of time that it takes for inflationary expectations to be reduced. Thus, if an monetary policy succeeds in reducing inflationary expectations, it will enable a government to reduce inflation with less unemployment than would otherwise be necessary. Monetarists argue that sustained and severe inflation can be produced only by excessive increases in the money supply. This view is backed up by an impressive amount of empirical evidence showing a correlation between increases in the money supply and consequent increases in the price level. Less extreme forms of the view that excess demand is the main cause of inflation tend to place more emphasis on fiscal, rather than monetary, factors as the source of the excess demand that is, government overspending, however financed, is seen as the main cause of inflationary pressure by some economists. Government expenditure is harmonized by an equal increase in government’s borrowings so as to keep the government’s budget incrementally balanced. Here, the government incurs additional indebtedness. Given this equal increases in government expenditure and borrowings, the change in the national income due to a change in government expenditure is referred as the balanced budget multiplier in macroeconomics. As government expenditure is matched by an equal increase in interest rates, the value of the balanced budget multiplier is unity. b) if the authorities reacts to current output and change it to The real output shows that the policy is effective in thus the model is held. The second model is more realistic than the first model. For , we can see that if increases, the equation would result in a lower value for the numerator. Thus if deficit increases it implies that national income would decrease. The same effect is experienced by the interest rate. That is if deficit increases then interest rate decreases as well. This analysis is easily linked to the aggregate supply-aggregate demand framework. In the case the long-run inflation rate is zero. For simplicity, suppose business-cycle fluctuations are brief enough that the short-run aggregate supply curve remains stable. The aggregate demand curve bounces up down, and output fluctuates between a high level, , and a low level, , on either side of the full-employment level as the aggregate demand curve moves up, we have the expansion phase of the cycle, during which output and the price level both rise. The model shows that inflation is deeply ingrained. References Branson, W.H. (1995). Macroeconomic Theory and Policy. Delhi: Virender Kumar Arya. Boyes, W. and Melvin, M. (2008), Economics, Boston: Houghton Mifflin Company. Hall RE, & Lieberman M (2009). Macroeconomics: Principles & Applications. New York: Cengage Learning. Jain, TR and VK Ohri, (n.d.). Introductory Microeconomics and Macroeconomics, FK Publisher. Romer's D. (2011).Advanced Macroeconomics. New York: McGraw-Hill Series Economics Ljungqvis, L. & Sargent, T. (2012) Recursive Macroeconomic Theory. New York: The MIT Press Read More