Question

Topic: Fiscal Policy

EXPANSIONARY FISCAL POLICY (deficit spending):

When (at which phase of business cycle) is it used?

What is expected as the policy outcomes?

Output (GDP):

Unemployment:

Price level:

How does interest rate increase under this policy?

- CROWDING-OUT EFFECT

Causes: Increase in interest rate

Effects/Outcomes:

- NET EXPORT EFFECT

Causes: Increase in interest rate

Effects/Outcomes:

CONTRACTIONARY FISCAL POLICY

When (at which phase of business cycle) is it used?

What is expected as the policy outcomes?

Output (GDP):

Unemployment:

Price level:

How does interest rate decrease under this policy?

- NET EXPORT EFFECT

Causes: Increase in interest rate

Effects/Outcomes:

Answer 1

a) A fiscal expansionary policy is used when the economy is in recession or is slowing down. It increases the government expenditure which leads to increase in transaction demand for money causing interest rate to increase at given money supply. When interest rate increases, it increases the cost of borrowing which leads to decrease in private investment (this is called crowding out effect, the decrease in private investment due to increase in government spending). Also, an increased interest rate attracts investors which increases the met capital inflow in the country leading to appreciation of the domestic currency. As currency has appreciated, so, exports become costly but imports become cheap increasing the demand for imports but decreasing the demand for exports this leads to a decrease in net exports (this is called the net-exports effect). The increased government spending increases the aggregate demand for goods and services which at given aggregate supply leads to an increase in price level and output. This increase in output leads to a decrease in unemployment as now more labor is required for production.

b) A fiscal contractionary policy is used when the economy is in a boom phase. It decreases the government expenditure which leads to decrease in transaction demand for money causing interest rate to decrease at given money supply. When interest rate decreases , it decreases the cost of borrowing which leads to increase in private investment. Also, a decreased interest rate dicourages investors which increases the met capital outflow from the country leading to depreciation of the domestic currency. As currency has depreciated, so, exports become cheaper but imports become expensive increasing the demand for exports but decreasing the demand for imports this leads to an increase in net exports (this is called the net-exports effect). The decreased government spending decreases the aggregate demand for goods and services which at given aggregate supply leads to a decrease in price level and output. This decrease  in output leads to an increase in unemployment as now less labor is required for production.

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