T-1, G-3.docx - EIA 2002 MACROECONOMICS 2 SEMESTER 2...

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EIA 2002 MACROECONOMICS 2 SEMESTER 2 2018/2019 LECTURER : DR. MOHD SAAD ASSIGNMENT GROUP : 1 MEMBERS : NAME MATRIC NO HII PUONG HUNG EIA170045 TAN JINGXIN EIA170173 YAP MAY CHING EIA170195 YEO JIN JIE EIA170207 Under the Classical system, the expansionary fiscal policy and expansionary monetary policy have no effect on output. Discuss.
Generally, the government may impose both expansionary fiscal policy and monetary policy to finance government spending (G). We have to take note that both policies might or might not have effect on the output level. There are three sources of financing used by the government: borrowing in which the government issues financial instruments such as bonds to gain loanable funds; increasing money supply ( M S ) in which the government prints money; and imposing tax policy in which the government increases tax rates that are categorized into two: lump sum tax (T) and marginal income tax (tY). There are two types of policies that the government can impose to finance the government spending (G). Expansionary fiscal policy includes the borrowing in which the government issues financial instruments such as bonds to gain loanable funds, increasing money supply ( M S ) in which the government prints money, and imposing tax policy in which the government increases tax rates that are categorized into two: lump sum tax (T) and marginal income tax (tY). Expansionary monetary policy is mainly about printing money to increase the supply of money ( M S ) in the money market. There are some assumptions that we need to take note. Each player in the market is able to gain perfect knowledge about wages and price. The market is a perfect competition that everyone is a price-taker. The wages and the price has a perfect flexibility so that full employment can always be achieved. Some equations below are obeyed: - N d = f ( W P ) - - N s = f ( W P ) + - I = I (r) - - S = S (r) +
FIGURE 1 Firstly, we would discuss about expansionary fiscal policy, where the government issues financial instruments such as bonds to gain loanable funds to finance the government spending (G). The equilibrium of loanable funds market is achieved by equating equilibrium interest rate (r) with the demand for loanable funds and the supply of loanable funds. The initial equilibrium 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 loanable funds, thus the government issues bonds to the public to finance the deficit. This shifts the demand 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 in interest rate produces two effects: savings increases from S0 to S1, and the amount of increment 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 rather than current consumption. The increment in savings is measured by distance A in the graph.

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