In: Economics
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).
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.