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Macro.Week11.2008 - II 11/1 Now before we move forward on...

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II - 11/1 Now before we move forward on exchange rates, we need to clean up a couple of “small” topics from fiscal and monetary policy. Topic #1 - Feedbacks through the interest rate When we did fiscal and monetary policy, we ignored feedback mechanisms through the interest rate. This topic is covered in detail in the second year macro course. What you need to know for this course is the following: IF EITHER EXPANSIONARY FISCAL POLICY OR EXPANSIONARY MONETARY “WORK” (That is, if they succeed in raising GDP) THEN THEY WILL INCREASE THE DEMAND FOR LIQUIDITY
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II - 11/2 Why is that? We have learned that people want liquidity in order to carry out their day-to-day business; if GDP is higher, then people have higher incomes, and they spend more, and thus they need more liquidity to carry out their purchases: Diagram of L shifting right when Y rises
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II - 11/3 For fiscal policy, expansionary fiscal policy ( G) increases AE and, unless the AS curve is vertical, this increases Y Increase in Y causes L to shift to the right, thereby increasing r. The increase in r will cause investment to fall, and this will partially cancel out the increase in G This is called CROWDING OUT , because the increase in G “crowds out” some private investment (The term was developed, I suspect, by those who do not like government involvement in the economy) Will crowding out ever cancel out the fiscal policy? In general no, because if it did, Y wouldn’t rise, so r wouldn’t rise, so no fall in I Trust me on this - you will cover it in ECMB06
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II - 11/4 Diagram for “Crowding Out”:
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II - 11/5 What about Expansionary Monetary Policy? Not as interesting. The increase in MS reduces r, increases I, increases AE and, unless the AS curve is vertical, this increases Y Increase in Y causes L to shift to the right, thereby increasing r. The increase in r will cause investment to fall, and this will partially cancel out the fall in r and the initial increase in I It will not entirely cancel it out, except in extreme cases. Trust me again
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II - 11/6 Diagram of this (no cute name here!).
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II - 11/7 Topic 2 - Will the deficit hurt the economy? 1. If the interest rate rises, and investment is crowded out, there will be a decrease in future private productivity. Of course, the public spending may be “public investment” (infrastructure, education) which will also increase productivity in the future. This is key issue, since we really owe most of debt to ourselves.
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