exam3test

exam3test - 1. Crowding out occurs when the government...

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1. Crowding out occurs when the government raises spending levels, which causes the interest rate to rise. As a result of the increased interest rates, investments decrease and are therefore crowded out by the increased government spending. In the graph the fiscal policy causes a shift in the IS curve expanding income and increasing the interest rate, which creates a balance of payment deficit. As a result the central bank sells foreign exchange, thereby, decreasing the money supply reducing interest rates and income slightly. Overall there is a increase in income and the interest rates, and partial crowding out. However, the crowding out is not complete because the rise in the interest rates in comparison to the increase in government spending to completely offset investment spending. 2. Monetary policy is ineffective under fixed exchange rates. Because the use of monetary policy causes a shift in the LM curve along the IS curve, which results in a balance of payment deficit. The central bank under fixed exchange rates then interferes by selling government bonds or foreign exchange and reduces the money supply. The reduced money supply causes the LM curve to move back towards its equilibrium. Thus, monetary policy causes no real change in terms of income and the interest rate and settles back at its previous equilibrium. 3. If Japan had been running a huge current account surplus. Then the expansion using fiscal policy would cause the IS curve to move upwards, and would create a incipient surplus in the balance of payments. The current account would degrade; however, the improvement in the capital account would more than offset this degradation. Since we would be under a fixed rate regime, the LM curve would move to right as a result of the central bank
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exam3test - 1. Crowding out occurs when the government...

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