Question

Suppose businesses become pessimistic future of the economy causing businesses to reduce their investments. Use the model of aggregate supply and aggregate demand to show what the Federal Reserve could do to offset the short-run changes in the aggregate supply and aggregate demand model. Explain your answer. HINT: You will need 2 different graphs: a money market graph and the aggregate supply – aggregate demand graph.

Answer 1

When businesses cut their spending or investment the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. This is called Crowding out effect. When the government buys a product from a company, the immediate impact of the purchase is to raise profits and employment at that firm.  As a result, owners and workers at this firm will see an increase in income, and will therefore likely increase their own consumption. If consumers want to purchase more goods and services, they will need to increase their holdings of money. This shifts the demand for money to the right, pushing up the interest rate.

The higher interest rate raises the cost of borrowing and the return to saving.  This discourages households from spending their incomes for new consumption or investing in new housing.  Firms will also decrease investment, choosing not to build new factories or purchase new equipment.Thus, even though the increase in government purchases shifts the aggregate demand curve to the right, this fall in consumption and investment will pull aggregate demand back toward the left.  Thus, aggregate demand increases by less than the increase in government purchases. Therefore, when the government increases its purchases by $X, the aggregate demand for goods and services could rise by more or less than $X, depending on whether the multiplier effect or the crowding-out effect is larger.

a.If the multiplier effect is greater than the crowding-out effect, aggregate demand will rise by more than $X.

b. If the multiplier effect is less than the crowding-out effect, aggregate demand will rise by less than $X.