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EIA 2002MACROECONOMICS 2SEMESTER 2 2018/2019LECTURER: DR. MOHD SAADASSIGNMENT GROUP: 1MEMBERS:NAME MATRIC NOHII PUONG HUNGEIA170045TAN JINGXINEIA170173YAP MAY CHINGEIA170195YEO JIN JIEEIA170207Under the Classical system, the expansionary fiscal policy and expansionary monetary policyhave no effect on output. Discuss.
Generally, the government may impose both expansionary fiscal policy and monetarypolicy to finance government spending (G). We have to take note that both policies might ormight not have effect on the output level. There are three sources of financing used by thegovernment: borrowingin which the government issues financial instruments such as bondsto gain loanable funds; increasing money supply (MS)in which the government printsmoney; and imposing tax policyin which the government increases tax rates that arecategorized into two: lump sum tax (T) and marginal income tax (tY).There are two types of policies that the government can impose to finance thegovernment spending (G). Expansionary fiscal policyincludes the borrowing in which thegovernment issues financial instruments such as bonds to gain loanable funds, increasingmoney supply (MS) in which the government prints money, and imposing tax policy inwhich the government increases tax rates that are categorized into two: lump sum tax (T) andmarginal income tax (tY). Expansionary monetary policyis mainly about printing money toincrease the supply of money (MS) in the money market.There are some assumptions that we need to take note. Each player in the market isable to gain perfect knowledge about wages and price. The market is a perfect competitionthat everyone is a price-taker. The wages and the price has a perfect flexibility so that fullemployment can always be achieved. Some equations below are obeyed:-Nd=f(WP)--Ns=f(WP)+-I = I (r) --S = S (r) +
FIGURE 1Firstly, we would discuss about expansionary fiscal policy, where the governmentissues financial instruments such as bonds to gain loanable funds to finance the governmentspending (G).The equilibrium of loanable funds market is achieved by equating equilibrium interestrate (r) with the demand for loanable funds and the supply of loanable funds. The initialequilibrium is achieved at [S0 = I + (G0 – T0)], having an interest rate level at r0, at point E.An increase in government spending (G) creates an increase in demand for loanablefunds, thus the government issues bonds to the public to finance the deficit. This shifts thedemand curve upwards to the right from I + (G0 – T0) to I + (G1 – T0).At r0, there is an excess of demand for loanable funds over supply of loanable funds,thus there is a pushing force towards interest rate to increase from r0 to r1. The increment ininterest rate produces two effects: savings increases from S0 to S1, and the amount ofincrement is exactly the same as the decrease of consumption level due to the equation of Y =C + S. Higher interest rate leads household to save more and prefer future consumption ratherthan current consumption. The increment in savings is measured by distance A in the graph.