Question

1. Assuming that factors to production are held fixed, explain how investment is affected by fiscal austerity(a decline in government spending) when taxes are held constant. make sure to explain in words and in a diagram. Explain how this compares to the crowding out of the investments scenario?

Answer 1

Austerity affect economic growth :

• The Global Crisis that began in 2008 has rekindled the debate on the impact of fiscal policy on economic growth. At the outset of the Crisis the focus was on whether fiscal stimulus boosts economic growth. Since 2011 or so, with the Crisis becoming more severe in some European countries and Greece in particular, the emphasis has shifted to whether fiscal adjustment should be seen as part of the emerging ‘consensus’ view (Baldwin and Giavazzi 2015) on the causes of the output loss. Several researchers have delved into the question using novel, sophisticated methods, but these have proved difficult to communicate to the public at large.
• Meanwhile, public discourse has been influenced by simple charts analysing the correlations between measures of fiscal ‘austerity’ and economic growth for small samples of countries over limited time periods. Academic studies have not further developed this approach, perhaps because of concerns about the direction of causality. Although such concerns are legitimate, the modest task of analysing empirical association in a more systematic manner may be worthwhile. In a recent study (Mauro and Zilinsky 2015), we explore the correlations in the data starting from the simplest and gradually building up – in a step-by-step, transparent manner – to multivariate regressions based on various samples of countries for different periods. The results show that simple correlations are no longer significant when considering slightly longer sample periods and omitting outliers, like Greece, from the sample. In multivariate regressions using broader samples, a tightening of fiscal policy is significantly associated with lower economic growth only in some specifications and estimation samples.
• An increase in government spending increases budget deficit, which increases government borrowing for higher deficit financing. As a result, interest rate will increase. Higher interest rate will decrease the quantity of investment demanded.
• In following graph, I0 is the investment demand curve. Initial position is at point A with initial interest rate r0 and quantity of investment demanded Q0. After interest rate rises to r1, the economy moves upward along I0 to point B with lower quantity of investment demanded Q1.

Crowding out :

• In economics, crowding out is a phenomenon that occurs when increased governmentinvolvement in a sector of the market economysubstantially affects the remainder of the market, either on the supply or demandside of the market.
• One type frequently discussed is when expansionary fiscal policy reduces investment spending by the private sector. The government spending is "crowding out" investment because it is demanding more loanable funds and thus causing increased interest rates and therefore reducing investment spending. This basic analysis has been broadened to multiple channels that might leave total output little changed or even smaller

Crowding out from government borrowing :

• One channel of crowding out is a reduction in private investmentthat occurs because of an increase in government borrowing. If an increase in government spending and/or a decrease in tax revenues leads to a deficit that is financed by increased borrowing, then the borrowing can increase interest rates, leading to a reduction in private investment. There is some controversy in modern macroeconomics on the subject, as different schools of economic thought differ on how households and financial markets would react to more government borrowing under various circumstances.

• Income increases more than interest rates increase if the LM (Liquidity preference—Money supply) curve is flatter.
• Income increases less than interest rates increase if the IS (Investment—Saving) curve is flatter.
• Income and interest rates increase more the larger the multiplier, thus, the larger the horizontal shift in the IS curve.