Many people associate high budget deficit with high interest rates and rising prices. Taxes are primarily...

Many people associate high budget deficit with high interest rates and rising prices. Taxes are primarily linked to income. Throughout this problem, assume that T=tY, where t is the net tax rate.

USE IS-LM and AD-AS frameworks to explain whether this association (that is, high budget deficits with high real interest rates and rising prices) is true in the short run, if the deficits are primarily due to expansionary fiscal policy (like increases in government purchases).
Use IS-LM and AD-AS frameworks to explain whether this association is true in the short run, if there is a sudden decline in consumer or business confidence.

Solutions

Expert Solution

i)Due to an expansionary fiscal policy as a result of an increase in the government purchases. In the IS-LM framework, the IS curve will shift upwards with no change in the LM curve since the money market remains unaffected in this case. Since the IS shifts upwards and to the right there is an increase in the interest rates and hence income. In the AD-AS framework, the AD curve shifts up and to the right (due to a shift in the IS curve) as a result of which the output and price levels increase. So the mentioned association is true in the Short Run, high expansionary fiscal policy leads to higher interest rates and higher prices.

ii) Due to a sudden decline in consumer or business confidence, two variables get affected either the consumption(consumer side) or investment(business side). A decline in either leads to a downward shift in the IS curve and LM curve remains unaffected. As a result of which the interest rates and the income level fall.

In the AD-AS framework, the AD curve shifts downwards as a result of downward shift in the IS curve. Because AD curve shift downwards and AS curve remains unchanged. The price level and income level falls.

So the association of high interest rates and higher prices is false in the Short Run in this case.

Rahul Sunny answered 1 month ago

Next > < Previous

Related Solutions

If the U.S. government runs a budget deficit that will reduce interest rates? True False

1. If the interest rate is rising and stock prices are simultaneously rising, then according to...

1. If the interest rate is rising and stock prices are simultaneously rising, then according to the fundamental theory of stock pricing There must be irrational agents in the market The expected dividends of firms must be falling The future price of the stock must be falling Expected dividends of firms must be rising 2. Consider the stable growth or steady state model of a stock price. If the price of the stock is $40 per share, the yield on...

What impact might a decrease in the U.S. federal budget deficit have on interest rates and...

What impact might a decrease in the U.S. federal budget deficit have on interest rates and exchange rates in the market for the U.S. dollar? (Assume the exchange rate is stated in terms of foreign currency per U.S. dollar.) A. Interest rates decrease and exchange rates increase. B. Interest rates increase and exchange rates decrease. C. Interest rates and exchange rates decrease. D. Interest rates and exchange rates increase.

And then there is the issue of the dividend yield: if interest rates are rising, then...

And then there is the issue of the dividend yield: if interest rates are rising, then the preferred stock becomes less valuable and trades at a lower price. And preferred stock is usually more expensive to purchase than common stock anyway. If you were to purchase a business’ stock, would you purchase preferred stock because of the dividend preference, or common stock?

How will a growing budget deficit affect the economy? Your answer should discuss interest rates, private...

How will a growing budget deficit affect the economy? Your answer should discuss interest rates, private investment, and aggregate expenditure. 8.5.2

Which answer is TRUE regarding bond prices and interest rates? Bond prices and interest rates move...

Which answer is TRUE regarding bond prices and interest rates? Bond prices and interest rates move in opposite directions. Interest rate risk is the risk that a company will default on its interest payments. The prices of short-term bonds display greater price sensitivity to interest rate changes than do the prices of long-term bonds. The price of a bond is the future value of the coupon payment and the face value.

Interest rates and bond prices, move inversely. For example, when interest rates decline, bond prices increase;...

Interest rates and bond prices, move inversely. For example, when interest rates decline, bond prices increase; when interest rates increase, bond prices decrease. Provide a quantitative example, illustrating the effect of interest rates on bond pricing? As well, explain how the length of bond maturity and higher/lower coupon rates can affect bond prices when interest rates rise and fall in the economy.

What are the chances of the people of Venezuela protesting rising prices? Would you ever protest...

What are the chances of the people of Venezuela protesting rising prices? Would you ever protest rising prices in the United States

To reduce the budget deficit, the government creates new unit taxes that generate $3 billion in...

To reduce the budget deficit, the government creates new unit taxes that generate $3 billion in revenue. How will this affect total surplus (i.e., consumer surplus + producer surplus)? a. Total surplus will be unaffected b. Total surplus will fall by less than $3 billion c. Total surplus will fall by $3 billion d. Total surplus will fall by more than $3 billion

If a government has a budget deficit, it must Group of answer choices: decrease taxes. decrease...

If a government has a budget deficit, it must Group of answer choices: decrease taxes. decrease its expenditures. increase taxes. borrow in the loanable funds market.

Subjects