Question

In the class discussion on the IS-LM model it was presumed that consumption (i.e. C) depended only on income (Y). In particular, we assumed

that C = c₀ + bY, where c₀ is a positive constant and b denote the marginal propensity to consume. However, it is plausible that consumption

may also depend on r. This would make sense if consumers borrow and r represents the cost of borrowing. Suppose that C = c₀ + bY – qr, where

it is presumed that q > 0.   It follows that if q rises:

	a.	fiscal policy will be more potent because there will be less crowding out
	b.	fiscal policy will be less potent because there will be less crowding out
	c.	fiscal policy will be less potent because there will be more crowding out
	d.	fiscal policy will be more potent because there will be more crowding out

Answer 1

Ans)-

Given, C = C₀ + bY -qr

Now, if govt. uses fiscal policy, then the Aggregate demand in the economy will rise at a given interest rate, thus IS curve will shift rightwards and the output or income (Y) in the economy will rise at a given interest rate. Now if output in the economy rises, then the transactional demand for money (represented by ‘kY’) would also rise and since the money supply is constant in the economy thus the speculative demand for money (represented by ‘hr’) must fall because we know that at equilibrium “money supply = transactional demand + speculative demand”.

So, due to decrease in speculative demand i.e. demand for assets, bonds etc, the interest rate (r) would rise.   

Now, due to rise in interest rate, since q is rising, then qr would also rise sharply and thus consumption, C = C₀ + bY -qr, would fall sharply or by larger magnitude and thus aggregate demand and then output (Y) in the economy would fall by larger magnitude.

And thus, we can say that the increasing ‘q’ leads to a more crowding out of income (Y). because output would fall by larger amount and this decreases the effectiveness of fiscal policy.

Hence, option ‘C’ is correct. i.e. fiscal policy will be less potent because there will be more crowding out.

NOTE: Income and output is same.