Question

Suppose government spending increases. Would the effect on aggregate demand be larger if the Federal Reserve held the money supply constant in response or if the Fed were committed to maintaining a fixed interest rate? Explain.

Answer 1

Effectiveness of fiscal policy while maintaining a fixed interest rate

Every economy in the world undergoes through the path of business cycle. Sometimes the economy fell in the grip of recession which reduces income, output and employment far below the potential level.

In other situations the economy will suffer from the heat of inflation. A period of high price and low purchasing power. Thus in a free market economy there is a lot of business instabilities.

The monetary and fiscal policies are the effective tools in the hands of government to control the rate of interest, income, output and employment in an economy.

During time of inflation the government can control the economy by a suitable fiscal policy of reduced public expenditure and increased taxes and a suitable monetary policy of decreased money supply and increased rate of interest.

At the time of recession the effective fiscal policy is to increase public expenditure followed by reduction in tax rate and a monetary policy of increased money supply with lower interest rate.

The effectiveness of fiscal policy without touching the monetary sector can be explained with the help of the following figure.

The initial equilibrium of the economy is at ‘e’ with ‘oy’ level of income and ‘or’ level of interest rate. When the government expands its fiscal policy either by a reduction in taxes or by an increase in expenditure the ‘IS’ curve shift from ‘IS’ to ‘IS₁’ increasing the level of income to ‘oy₁’ and rate of interest to ‘or₁’. As the supply of money remaining the same an increase in rate of interest reduce the liquidity preference of the people. At high rate of interest the monetary assets especially the bond price is so attractive. The people will invest their money in bonds. So the excess money in the hands of the people due to increase in public expenditure or tax reduction will wipe out the higher rate of interest from Or₁ to or. As the rate of interest falls from or₁ to or investment increase which further increase the level of income from oy₁ to oy2. At lower level of interest people’s demand for money increase which cause a shift in LM curve from LM to LM₁. Thus a new equilibrium is achieved with same interest rate and increased level of income.

LM is the demand for and supply of money. L is the liquidity preference(demand for money) M is the moeny supply. IS is the investment and saving.

In conclusion the government can maintain a fixed rate of interest and high level of income by following a suitable fiscal policy without touching the money segment of the economy.