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ECON1000 CH. 15 continued.docx

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ECON 1000
Nick Rowe

Chapter 15 continued • Start with an example (based on material covered during Monday's lecture) • Finish analysis of fiscal policy An Aside • Distinction between saving and investment • Saving: when your income exceeds consumption o Deposit those savings in a bank, purchase bonds or stock o Sometimes referred to as investment?? o The higher r (interest rate), the more you save (i.e. higher return on saving) • Investment: the purchase of new capital, such as equipment, building a new factory or a new house o Investment is I in the GDP formula: Y = C + I + G + NX o The higher the interest rate ( r ) the less you and companies invest (i.e. more cost to borrow) Example: Fiscal Expansion in an Open Economy with a Flexible Exchange Rate • Suppose government spending increases in an open economy • What would be the effect on aggregate demand? Explain. • In your answer: o Refer to the mutliplier effect o The crowding out effect on investment and the crowding out effect on net exports o Use diagrams to illustrate your answer What has Happened? •Government has increased AD through greater spending •The stimulus has been fully offset by the two crowding out effects o Crowding out effect due to lower investment (higher r = lower investment) o Crowding out effect due to lower net exports (appreciation of exchange rate and therefore lower net exports) •This holds for an open economy with flexible exchange rate (the exchange rate is left free to adjust) Open Economy Considerations: Fixed Exchange Rate •To offset the higher interest rate and appreciation of CDN dollar Bank of Canada can increase the money supply by selling dollars in the market for foreign-currency exchange •This has two effects: o Prevents CDN $ from appreciating o Also, this increases the Money Supply (MS) overall; prevents the interest rate from rising (changing) •As a result, both forms of crowding out are avoided •In the end, the fiscal expansion has a large effect on aggregate demand Fiscal Expansion in an Open Economy Recap •Without accomadating monetray policies (with flexible exchange rate) o There are crowding out effects due to lower investment, lower net exports o Hence fiscal stimulus is fully offset •With accomadating monetary policies (an increase in MS to fixed exchange rate) o Crowding out does not occur o Fiscal stimulus is implemented Changes in Taxes • Government can increase aggregate demand by cutting taxes, such as income taxes • When the government cuts personal income taxes, it increases household's take-home pay • Households: o Save some of this additional income o Spend the remainder on consumer goods • The increases spending shifts the aggregate demand curve to the right • The size of the shift in aggregate demand: o Is affected by the multiplier and crowding out effects o Outcome is similar to that resulting from increased government spending o Only difference ois that it works through consum
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