Question

Consider a government that wants to raise investment spending in the economy. Perhaps the government is concerned about future economic growth and so wants to promote investment in order to raise growth. However, the government also does not want to increase inflation. Inflation could be caused by excessively high output growth pushing up prices. Therefore, the government does not want output to increase more than normal. Use the following questions to think about how the government could raise investment without raising output.

a) What would raise investment: higher or lower interest rate

b) Given your answer to (a), what should the Federal Reserve do to the money supply

c) What impact does the Fed’s action in (b) have on output?

d) Explain how a fiscal policy could offset the change to output in (c) without offsetting the change in interest rates in (b).

Answer 1

a) What would raise investment: higher or lower interest rate/
A majority of investment spending is funded by debt. Lower interest rates by the Fed will likely be translated into lower lending rates by banks. This should spur investment spending in the economy.

b) Given your answer to (a), what should the Federal Reserve do to the money supply
Interest rates are an inverse function of money. For example, Fed increases money supply by Open Market Operations, it buys securities from banks and gives them money in exchange. Now this would increase the amount of loanable funds that are available with the banks. As a consequence, this would reduce interest rates.

c) What impact does the Fed’s action in (b) have on output?
Fed's actions would increase output as well. Lower interest rates would spur consumer spending and discourage savings. This would lead to an increase in aggregate demand.

d) Explain how a fiscal policy could offset the change to output in (c) without offsetting the change in interest rates in (b).
The increase in aggregate demand would increase inflation. In order to counter this fiscal policy can use a number of different measures. It could reduce non investment expenditure by the government so that the total aggregate demand in the economy remains the same. It could discourage consumption expenditure and encourgage investment through taxes on consumption goods or increasing sales tax.