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 government’s 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.

5. 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.

6. 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).

7. Monetary Policy Inflation Real Output Increase Increase Decrease Decrease Increase Increase Decrease Decrease Increase Increase Decrease Decrease

8. Fiscal Policy Inflation Real Output 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.

10. 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. 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. 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 year’s 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. 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. There’s 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.

14. Crowding-Out: A Graphical Representation • Sources of government borrowing: • Treasury Bills • Treasury Notes • Treasury Bonds

15. Interest Rate • Government’s demand for funds increases the demand for money. MS i1 MD1 i MD Money

16. Nominal Interest Rate PL Fig. 44.1: Crowding-Out Using AD and AS Analysis MS SRAS p i MD AD Real GDP Y* Quantity of Money • 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.

17. Nominal Interest Rate PL MS SRAS • Which curve did you shift in the short-run AD and AS supply graph? What happens as a result of this new curve? p1 p AD1 i MD AD Real GDP Y* Y1 Quantity of Money Shift the AD curve to AD1, as a result of the expansionary fiscal policy. The PL and Y both increase

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

19. Nominal Interest Rate PL MS SRAS • Given the change in interest rates, what happens in the short-run AS and AD graph? p1 i1 p2 p AD1 i AD2 MD1 AD MD Real GDP Quantity of Money Y* Y2 Y1 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.

20. Nominal Interest Rate PL MS MS1 SRAS • 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. p1 i1 p2 p AD1 i AD2 MD1 AD MD Real GDP Quantity of Money Y* Y2 Y1 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.

21. 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 • I and i are the initial equilibrium values. • D = private sector demand for funds (Investment) • D + (G–T) = 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) i1 i D + (G – T) D I2 I I1 Quantity of Loanable Funds

22. Interest Rate S i1 • 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. i D + (G – T) D Quantity of Loanable Funds I2 I I1

23. 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 I2 I I1

24. 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 I2 I I1

25. 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 I2 I I1

26. 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.

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

28. Fig. 44.2: Loanable Funds Market Interest Rate S i1 • What happens to the interest rate as a result of this expansionary fiscal policy? Explain. i D1 D Quantity of Loanable Funds There is an increase in the demand for loanable funds to pay for the increased government spending. The interest rate rises to i1

29. Fig. 44.2: Loanable Funds Market Interest Rate S i1 • Indicate on the graph the new quantity of private demand for loanable funds. i D1 D Q Quantity of Loanable Funds At the higher interest rate (i1), the level of private demand for loanable funds is Q

30. Interest Rate S S1 i1 i 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. D1 D Q Quantity of Loanable Funds 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.

31. Part C: Applications • 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.

32. 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. What effect would this policy have on bank reserves and the money supply? • 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. 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. What effect would this policy have on bank reserves and the money supply? • 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. 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.