Policy Lags and Crowding-Out Effect

1
Policy Lags and Crowding-Out Effect

• Unit 5 Lesson 1
• Activities 43 44
• Goodman, Rae Jean B.. U.S. Naval Academy
• Advanced Placement Economics Teacher Resource
  Manual. National Council on Economic Education,
  New York, N.Y

2
Objectives

• Explain inside and outside lags for monetary and
  fiscal policy.
• Define the crowding-out and the Barro-Ricardo
  effect.
• Explain the effects of crowding-out within the
  short-run AD and AS model.
• Explain how the Barro-Ricardo effect can reduce
  the crowing-out effect while simultaneously
  reducing the effects of the fiscal policy.
• Demonstrate the use of monetary policy to lessen
  or reinforce the crowding-out effect.

3
Introduction

• This lesson discusses the lags associated with
  monetary and fiscal policy making and analyzes
  the direct and indirect effects of government
  budget deficits.
• The direct effect of these deficits is an
  increase in interest rates.
• When the government borrows money to finance its
  deficit, this results in an increase in the
  demand for money, or, alternatively, the demand
  for loanable funds. This in turn results in an
  increase in the interest rate.

4

• A higher interest rate causes decreases in
  investment and other interest sensitive
  components of AD.
• Crowding-out is the decrease in private demand
  for funds that occurs when the governments
  demand for funds causes the interest rate to
  rise
• The demand by government for loanable funds
  decreases or crowds-out the private demand for
  loanable funds.

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Lags Associated With Policy Making

• The inside lag consists of the time it takes for
  data to be collected, policy makers to recognize
  that policy action is necessary, the decision
  about which policy should be taken and the
  implementation of the policy.
• The outside lag is the time it takes the economy
  to respond to the new policy. These lags differ
  in length for monetary policy and fiscal policy.

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Activity 43 Monetary and Fiscal Policy

• Part A Tools of Monetary and Fiscal Policy
• Both monetary and fiscal policy can be used to
  influence the inflation rate and real output.
  Indicate what effect each specific policy has on
  inflation and real output in the short-run (9 to
  18 months).

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Monetary Policy
Inflation
Real Output
1. (A) Buy government securities    
(B) Sell government securities    
2. (A) Decrease the discount rate    
(B) Increase the discount rate    
3. (A) Decrease reserve requirement    
(B) Increase reserve requirement    
Increase
Increase
Decrease
Decrease
Increase
Increase
Decrease
Decrease
Increase
Increase
Decrease
Decrease
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Fiscal Policy
Inflation
Real Output
4. (A) Increase government spending    
(B) Decrease government spending    
5. (A) Increase taxes    
(B) Decrease taxes    
Increase
Increase
Decrease
Decrease
Decrease
Decrease
Increase
Increase
9
Part B Lags in Policy Making

• As the economic situation changes, policy makers
  must decide when to take action and what policy
  action to take. Then they must implement the
  policy.
• The economy then responds to the policy. The
  amount of time it takes policy makers to
  recognize and take action is called inside-lags.
• The amount of time it takes the economy to
  respond to the policy changes is called outside
  or impact lags.

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• The inside lag is estimated to be short for
  monetary policy, but long for fiscal policy.
• The inside lag is long for fiscal policy because
  the legislative branch must come to agreement
  about the appropriate action.
• The outside lag, however, is long and variable
  for monetary policy but very short for the fiscal
  policy.

11

1. Explain why the inside lag can be short for
   monetary policy, but the outside lag is long and
   variable.

The Federal Reserve can change the money supply
on a daily basis through open market operations.
Thus, once the Open Market Committee decides on a
particular policy, the policy can be implemented
immediately. However, monetary policy works
through changes in interest rates and the
response of interest-sensitive components of AD
to the interest rate changes. The response of
investment and consumption takes time.
12

1. Explain why the outside lag is short for fiscal
   policy.

The outside lag is short for fiscal policy for
several reasons (1) Fiscal policy has been
debated in Congress and discussed extensively in
the media. Thus, as soon as it is enacted,
people can respond. (2) If the fiscal policy is a
tax change, the effects will be within a years
time. (3) If the fiscal policy is an expenditure
change, the effect will be felt almost
immediately as the affected agency changes its
spending pattern.
13

1. Explain why lags are important to the discussion
   of stabilization policy.

The existence of policy lags implies that policy
actions could be out of sequence with the
economy. For example, expansionary policy might
have its impact after the economy has started to
recover from a recession. As a result, the
expansionary policy may create inflation because
it over stimulates the economy. This problem has
led some economies to recommend policy
rules. Examples of policy rules are that money
supply should grow at 5 a year and nominal GDP
should grow at 6 a year. Theres a second
reason why understanding lags is important for
stabilization policy. Policy makers should not
think that policy can fine-tune the economy at
any point in time.
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Crowding-Out A Graphical Representation

• Sources of government borrowing
• Treasury Bills
• Treasury Notes
• Treasury Bonds

15

• Governments demand for funds increases the
  demand for money.

Interest Rate
MS
i1
MD1
i
MD
Money
16

• Fig. 44.1 Crowding-Out Using AD and AS Analysis

Nominal Interest Rate
PL
MS
SRAS
p
i
MD
AD
Real GDP
Quantity of Money
Y

1. Assume fiscal policy is expansionary and monetary
   policy keeps the stock of money constant at MS.
   Shift one curve in each graph to illustrate the
   effect of the fiscal policy.

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Nominal Interest Rate
PL
MS
SRAS
p1
p
i
AD1
MD
AD
Real GDP
Quantity of Money
Y
Y1

1. Which curve did you shift in the short-run AD and
   AS supply graph? What happens as a result of
   this new curve?

Shift the AD curve to AD1, as a result of the
expansionary fiscal policy. The PL and Y both
increase
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Nominal Interest Rate
PL
MS
SRAS
p1
i1
p
AD1
i
MD1
AD
MD
Real GDP
Quantity of Money
Y
Y1

1. In the money market graph, which curve did you
   shift to demonstrate the effect of the fiscal
   policy? What happens as a result of this shift?

Shift the MD curve to the right money demand
increased because real GDP increased. Interest
rate rises.
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Nominal Interest Rate
PL
MS
SRAS
p1
i1
p2
p
AD1
i
AD2
MD1
AD
MD
Real GDP
Quantity of Money
Y
Y1
Y2

1. Given the change in interest rates, what happens
   in the short-run AS and AD graph?

AD shifts back to AD2 because the increase in
interest rates reduces some private domestic
investment and interest-sensitive consumer
spending. This is crowding-out.
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Nominal Interest Rate
PL
MS
MS1
SRAS
p1
i1
p2
p
AD1
i
AD2
MD1
AD
MD
Real GDP
Quantity of Money
Y
Y1
Y2

1. How could a monetary policy action prevent the
   changes in interest rates and output you
   identified in (B) and (C)? Shift a curve in the
   money market graph, and explain how this shift
   would reduce crowding-out.

Shift the money supply curve to MS1. If the
money supply is increased to MS1, interest rates
would move back to i. If interest rates are at
i, there would be no crowding-out (or reduction)
of investment spending, and the AD would be AD1.
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Loanable Funds Market
Note The original demand curve is for the
private sector ONLY. At the beginning there is
no borrowing or debt by the federal government.
The increase in government demand for funds
crowds-out private investment.
Interest Rate
S
i1
i
D (G T)
D
I
I1
I2
Quantity of Loanable Funds

• I and i are the initial equilibrium values.
• D private sector demand for funds (Investment)
• D (GT) private government demand for funds
• I1 and i1 are the new equilibrium values.
• I2 new level of private investment
• I1 I2 government demand for funds (G T)

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Interest Rate
S
i1
i
D (G T)
D
Quantity of Loanable Funds
I
I1
I2

• I2 is the quantity of loanable funds demanded by
  the new equilibrium because at i1 (the
  equilibrium interest rate), I2 is the quantity of
  investment funds the private sector demands, as
  shown by the private-sector demand curve.

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Barro-Ricardo Effect

• According to Barro-Ricardo effect budget deficit
  has no effect on the real interest rate or
  investment. This means that financing government
  purchases by taxes or by borrowing is equivalent.

Interest Rate
S
i1
i
D (G T)
D
Quantity of Loanable Funds
I
I1
I2
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Barro-Ricardo Effect

• The supply curve for funds will shift rightward.
  The rightward shift in the supply curve reduces
  the increase in the interest rate and reduces the
  decrease in the private sector demand for funds.
  Thus, the crowding-out effect is reduced if there
  is a Barro-Ricardo effect.

Interest Rate
S
i1
i
D (G T)
D
Quantity of Loanable Funds
I
I1
I2
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Barro-Ricardo Effect

• There is little evidence that the Barro-Ricardo
  effects very large.
• However, crowding-out can be significant,
  depending on the elasticity of investment and
  interest-sensitive components of AD.

Interest Rate
S
i1
i
D (G T)
D
Quantity of Loanable Funds
I
I1
I2
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Part B Using the Loanable Funds Market

• The loanable funds market provides another
  approach to looking at the effects of increases
  in the budget deficit.
• The demand for funds in the loanable funds
  market comes from the private sector (business
  investment and consumer borrowing), the
  government sector (budget deficits) and the
  foreign sector.
• The supply of funds in the loanable funds market
  comes from private savings (businesses and
  households), the government sector (budget
  surpluses), the Federal Reserve (money supply)
  and the foreign sector.

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Fig. 44.2 Loanable Funds Market
Interest Rate
S
i1
i
D1
D
Quantity of Loanable Funds

1. Shift one of the curves on Fig 44.2 to indicate
   what occurs in the loanable funds market if
   government spending increases without any
   increases in tax revenue or the money supply.

The demand increases, shifting the demand curve
to D1. D1 represents the private plus public
demand for loanable funds.
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Fig. 44.2 Loanable Funds Market
Interest Rate
S
i1
i
D1
D
Quantity of Loanable Funds

1. What happens to the interest rate as a result of
   this expansionary fiscal policy? Explain.

There is an increase in the demand for loanable
funds to pay for the increased government
spending. The interest rate rises to i1
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Fig. 44.2 Loanable Funds Market
Interest Rate
S
i1
i
D1
D
Quantity of Loanable Funds
Q

1. Indicate on the graph the new quantity of private
   demand for loanable funds.

At the higher interest rate (i1), the level of
private demand for loanable funds is Q
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Interest Rate
S
S1
i1
i
D1
D
Quantity of Loanable Funds
Q

• C. An accommodating monetary policy could
  prevent the effects you described in (A) and (B).
  Shift a curve in the diagram to show how the
  accommodating monetary policy would counteract
  the effects of crowding-out. Explain what would
  happen to interest rates and the level of private
  demand for loanable funds as a result of this new
  curve.

If the monetary authorities expanded the money
supply to keep interest rates constant at the
original level, a larger quantity of loanable
funds would be available, and there would be no
crowding-out. The new supply curve in S1,
interest rates return to i and the private sector
receives the original level of loanable funds.
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Part C Applications

1. Indicate whether you agree (A), disagree (D) or
   are uncertain (U) about the truth of the
   following statement and explain your reasoning.
   Exhaustion of excess bank reserves inevitably
   puts a ceiling on every business boom because
   without money the boom cannot continue.

Uncertain. The answer should depend on the
assumptions that are made. The boom could
continue to grow if the velocity of circulation
increases. Increased demand for a fixed money
stock would tend to increase interest rates, and
increased velocity is associated with higher
interest rates. However, the higher interest
rates could cause investment to decrease and slow
economic growth.
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• Answer the questions that follow each of the
  scenarios below.
• The Federal Reserve Open Market Committee wishes
  to accommodate or reinforce a contractionary
  fiscal policy.
• Would the Fed buy bonds, sell bonds or neither?
• What effect would this policy have on bond prices
  and interest rates?

Sell bonds.
Bond prices would decrease, and the interest rate
would increase.
33

1. What effect would this policy have on bank
   reserves and the money supply?
2. What effect would this policy have on the
   quantity of loanable funds demanded by the
   private sector?

Bank reserves would decrease, and the money
supply would decrease.
The bond sale would decrease the supply of
loanable funds the increase in the interest rate
would decrease the quantity demanded of loanable
funds (movement along the demand curve).
34

1. What effect would the change in interest rates
   you identified in (B) have on aggregate demand?

AD would decrease because the higher interest
rates would curtail the interest-sensitive
components of consumption and investment.
35

• The Federal Reserve Open Market Committee wishes
  to accommodate or reinforce an expansionary
  fiscal policy.
• Would the Fed buy bonds, sell bonds or neither?
• What effect would this policy have on bond prices
  and interest rates?

Buy bonds.
The price of bonds would increase, and the
interest rate would decrease.
36

1. What effect would this policy have on bank
   reserves and the money supply?
2. What effect would this policy have on the
   quantity of loanable funds demanded by the
   private sector?

Bank Reserves would increase and the money supply
would increase.
The quantity demanded of loanable funds would
increase.
37

1. What effect would the change in interest rates
   you identified in (B) have on AD?

AD would increase because of the lower interest
rates and the resulting increase in
interest-sensitive components of consumption and
investment.