Question

Question 2

1. Differentiate with appropriate examples between contractionary and expansionary monetary policies.                                                                                    

2. (i)Suppose that there are no crowding-out effects and the MPC is 0.9. By how

much must the government increase expenditures to shift the aggregate demand curve right by RM10 billion?

2. Suppose that the government increases expenditures by RM150 billion while increasing taxes by RM150 billion. Suppose that the MPC is 0.80 and that there are no crowding out effects. What is the combined effect of these changes? Why is the combined change not equal to zero?            

Answer 1

1.

Monetary policy refers to the use of appropriate monetary tools like open market operations, changing reserve ratios and discount rates to affect money supply in the economy and bring it close to its natural rate of output

Expansionary monetary policy involves usage of open market purchase of securities, lowering discount rate or reserve ratio to increase money supply in the economy

Contractionary monetary policy involves usage of open market sale of securities, increasing discount rate or reserve ratio to decrease money supply in the economy

2.

MPC = 0.9

Government spending multiplier = 1/(1-MPC) = 1/(1-0.9) = 10

G multiplier = Change in AD / Change in G

Change in G = 10 /10 = 1 RM billion

Thus, Government must increase expenditure by RM 1 billion

3.

MPC = 0.8

MPS = 1-MPC = 0.2

G multiplier = 1/MPS = 1/0.2 = 5

Tax multiplier = -MPC/MPS = -0.8/0.2 = -4

When G increases by 150, AD will increase by 150 x 5 = 750

When T increases by 150, AD will decrease by 150 x 4 = 600

Net effect = 750 - 600 = RM 150 billion

The combined effect is not zero because there is difference in tax multiplier and government spending multiplier