Monetary and Fiscal Policy Monetary and Fiscal Policy Combinations: Stabilization Combinations: Stabilization

Policy in the Real WorldPolicy in the Real World

Policy Lags and Crowding-Out Policy Lags and Crowding-Out EffectEffect

►Effects of Government Budget Deficits:Effects of Government Budget Deficits: Direct Effect: Increase in interest rates and Direct Effect: Increase in interest rates and

crowding outcrowding out►Crowding out is the decrease in private demand Crowding out is the decrease in private demand

for funds that occurs when the government’s for funds that occurs when the government’s demand for funds causes the interest rate to rise. demand for funds causes the interest rate to rise.

Indirect Effect: possibility of increase of Indirect Effect: possibility of increase of private savings and decrease in consumption private savings and decrease in consumption that offsets predicted expansionary effects of that offsets predicted expansionary effects of expansionary policy (expansionary policy (Barro-Ricardo EffectBarro-Ricardo Effect))

Policy LagsPolicy Lags

► Inside Lag: Time it takes for data to be Inside Lag: Time it takes for data to be collected, policy makers to recognize collected, policy makers to recognize the policy is necessary, decision about the policy is necessary, decision about which policy should be taken, and the which policy should be taken, and the implementation of the policyimplementation of the policy

►Outside Lag: Time it takes for the Outside Lag: Time it takes for the economy to respond to the new policy economy to respond to the new policy (differ in length for monetary and fiscal (differ in length for monetary and fiscal policies)policies)

Government Demand for Funds Government Demand for Funds Increases Demand for MoneyIncreases Demand for Money

Loanable Funds MarketLoanable Funds Market► 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)

The Effects of Policy Changes inThe Effects of Policy Changes inMultiple MarketsMultiple Markets