ECON 101 Lecture Notes - Lecture 8: Capital Accumulation, Income Tax, Loanable Funds

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26 May 2018

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Economics 101

Lori Leachman

Part 8 • Lecture

• Fiscal Policy

o Classical arguments against

▪ Can lead to crowding out

▪ Highly distortionary

▪ Inefficient - government doesn’t spend most effectively

▪ Takes a while to pass fiscal policy - timing is usually too late

• Crowding out

o Classicals believe economy always moves towards full employment

▪ Supply will be met by demand

▪ Always starts at equilibrium close to full employment

• Doesn’t even consider keynesian range

▪ Knows that crowding out is more likely when closer to full employment

• Can lead to inefficiencies

• If in keynesian range, no investment even happening - idle resources

o Crowding out results from expansionary fiscal policy that raises market interest rates &

lowers investment

o LOOK AT THE fiscal expansionary policy graphs

o Happens in the SHORT RUN

▪ Increased G (gov deficit spending)

• Increases TS and AD

• Increased G lead to bigger deficit - so gov needs to borrow more - gov sell more

bonds to finance deficit - Demand of Loans increases

o Demand increases, r increases

▪ (Higher deficit, higher risk, higher return as seen in increased

deficit spending G, increased r)

▪ Interest rate i increases and investment I decreases

• Decreased investment decreases TS and AD (so

opposite of before)

o Leading to lower Y income and lower price

level PL

o Long run

▪ Decreased investment I causes AS to decrease (shift in)

• This is due to lower growth and less capital accumulation

• This leads to lower income level Y and higher price level PL

o Higher price level decreases TS due to wealth and interest rate effects -

less consumption due to less Purchasing Power

• Crowding out - short term boost, long term detrimental effects - policy makers just wanna look good

• How to avoid crowding out

o Complement fiscal policy with monetary policy - increase MS - monetize debt

▪ Increase supply of loans

• The increase in S of loans ideally matches the increased demand for loans due to

the increased deficit due to increase G spending

o This stabilizes r, which would otherwise increase, increasing i and

decreasing investment I - leading to crowding out

▪ Happens in market

o Capital inflow - liberate capital accounts so foreigners finance deficit

▪ Increase supply of loans

• Same thing as complementing fiscal policy with monetary action - ideally

stabilizes r, or mitigates the change

o Lessen the change that would otherwise happen

o Offer business tax credit - promote business investment

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Document Summary

Part 8 lecture: fiscal policy, classical arguments against, can lead to crowding out, highly distortionary, takes a while to pass fiscal policy - timing is usually too late. If in keynesian range, no investment even happening - idle resources: crowding out results from expansionary fiscal policy that raises market interest rates & lowers investment, look at the fiscal expansionary policy graphs, happens in the short run. Increase supply of loans: same thing as complementing fiscal policy with monetary action - ideally stabilizes r, or mitigates the change, lessen the change that would otherwise happen, offer business tax credit - promote business investment. Increases marginal efficiency of investment mei: provides for example accelerated depreciation, corp tax cut, investment tax credit (more deficit - more demand) lol more expansionary, so even though r increases due to increased demand, which also increases i, Increased r, increased i, increased i (bc new mei) Increased i increases ts, increases ad: long run.

Related Questions

41.Which of the following is a valid statement about the Keynesian and classical models of the macroeconomy?

A. Fiscal policy will affect output in the Keynesian model, but only the price level in the classical model.

B. The economy adapts quickly to demand shocks under the Keynesian model, but not under the classical model.

C. A sharp decrease in the value of a nation's currency will lead to higher price levels in the Keynesian model, but not in the classical model.

D. Increases in autonomous expenditure will increase aggregate demand in the Keynesian model, but not in the classical model.

E. An increase in the productive capacity of an economy will result in greater output in both the Keynesian and classical models.

42. Suppose the government spends $500M on a project that has absolutely no value to the country. Which statement about this project is correct?

A. If taxes were raised $500M to fund this project, the Keynesian model predicts that this will have no net effect on output in the economy.

B. If the government raised the money for this project by printing $500M in bonds and selling them to the Fed, the effect is exactly the same as if they sold the bonds to households.

C. The project will increase aggregate supply because it will increase the total quantity of goods and services supplied in the economy.

D. If the marginal propensity to save in the economy is equal to 0.25, the Keynesian model predicts that this project will result in a $2000M increase in GDP.

E. Under the assumptions of the classical model, the result of this project will be increased in both the price level and equilibrium GDP.

43. A particular economy has a consumption of $400M, a government deficit of $100M, taxes of $250M, and income of $800M. Which of the following statements must be true?

A. If the investment is zero, there is no foreign trade imbalance.

B. If the trade surplus is $50M, the investment will be equal to $100M.

C. If the capital account surplus is $50M, the investment will be equal to $100M.

D. If the trade surplus is $100M, there will be an investment.

E. None of the above statements is necessarily true.

44. Which piece of information would be least useful in trying to predict the effect of a $700M increase in government spending on equilibrium GDP?

A. marginal propensity to save

B. The slope of the aggregate supply curve

C. Whether taxes are raised to pay for the spending increase

D. The current level of structural unemployment

E. Whether the bonds used to finance the spending were sold to households or to the Fed

45.Which of the statements relating to full employment and full capacity is false?

A. At full employment there is no frictional unemployment; at full capacity, there is no structural unemployment.

B. The full-employment level of output is less than the full capacity level of output.

C. At full employment there is no cyclical unemployment; at full capacity, there is no frictional unemployment.

D. A government spending increase will result in increased output and price levels at full employment, but only increased price levels at full capacity.

E. In the long run, an economy that starts at full capacity will move to full employment.

46. What would be the effect of a law requiring that government spending equal tax revenues in each year?

A. Fiscal policy would be completely eliminated as a tool to control the macroeconomy.

B. Monetary policy would be completely eliminated as a tool to control the macroeconomy.

C. Fluctuations in GDP would become less severe.

D. The government spending multiplier would be effectively set to 1.0.

E. The marginal propensity to consume would be cut in half.

47.The total value of T-bonds, including T-notes and T-bills, in existence at any point in time, is:

A. The federal government spending deficit.

B. The trade deficit.

C. Less than government spending.

D. Necessarily less than GDP.

E. The national debt.

48. Which of the following would be a valid statement about a government plan to eliminate a trade deficit

A. A decrease in the trade deficit will decrease investment in the country.

B. An effective strategy would be to increase the money supply and increase the value of the national currency.

C. An effective strategy would be to increase interest rates and increase the value of the national currency.

D. This could be achieved through dramatically increasing aggregate supply.

E. The increase in net exports will result in a decrease in aggregate demand.

49. Crowding out has the effect(s) of:

A. Reducing the effectiveness of monetary policy if crowding out occurs in financial markets.

B. Decreasing the value of a nationâs currency if the crowding out occurs in financial markets.

C. Increasing the effectiveness of fiscal policy if the crowding out occurs in financial markets and increasing the effectiveness of monetary policy if the crowding out occurs in product markets.

D. Decreasing the effectiveness of fiscal policy if the crowding out occurs in financial markets and decreasing the effectiveness of both fiscal and monetary policy if the crowding out occurs in product markets.

E. Increasing the price of government bonds if the crowding out occurs in financial markets.

50. Which of the following will make crowding out in credit markets more severe?

A. A steep investment demand curve

B. A global credit market

C. Tax increases

D. A steep supply curve in the loanable funds market

E. None of the above

peachmacaw787

1. Why Niall Ferguson thought that the expansionary fiscal policy (or government deficit) could produce crowding-out effect? You can explain by using the IS-LM model or you can use the logic of loanable funds theory

Answer: Ferguson believes that an increase in the government deficit could produce a crowding-out-effect. First, I will touch base on fiscal policy. Well, what is it? Basically, it adjusts the nationâs spending amount which increases the economyâs deficit to close a recessionary gap, which therefore increases the the demand for loans, meaning people want to borrow money. An increase in demand for loans leads to an increase in interest rates. Higher interest rates lead to a decrease in investment and interest-sensitive consumer spending, so both C and I decrease. Thatâs what the crowding-out-effect is, the decrease in investment due to higher interest rates.

>in Deficit = >in Demand for Loans = >in interest rates =

The government speeds up the economy by deficit spending, they crowd out consumers and investors with high interest rates. So what this means is that the government is attempting to help the economy but it is actually hurting the economy. The reason why I think Ferguson believes this is because of what he says in his debate at the New York Review of Books, that âyou canât be both a monetarist and a Keynesian simultaneouslyâat least I canât see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.â He continues on in the interview to say that the Fed has minted out a fresh $1.75 billion in bonds and that no one is going to buy them. Driving up bonds will increase interest rates which increases mortgage rates which is why he basically doesnât agree with the Keynesian theory.

2. Why Paul Krugman thinks that Niall Ferguson was wrong and thought that government deficit could not produce a crowding-out effect? In other words, please explain Krugman's Liquidity trap .

Answer: To start I think Krugman believes that the Fiscal policy is effective. It is effective when the Liquidity-Money (LM) curve is horizontal. It creates the crowding in effect. The supply of money is constant so it creates money demanded to be interest inelastic, meaning it doesnât change. So if the government wishes to stimulate the economy, it leaves interest rates at a constant rate, and an increase in investment and saving, therefore helping the economy close the gap on a recession. There is an indifference between money and bonds so this makes fiscal policy effective. So then we get into a monetary expansion, meaning we have an increase in the money supply. Well with the liquidity trap, we get the case that the investment-savings (IS) curve is horizontal. So when the government increases the money supply, investment responds to rapidly changing interest rates, which would decrease the money demanded, making monetary policy effective. But the liquidity trap becomes apparent because interest rates cannot fall below zero percent. This is when monetary policy would become ineffective because interest rates arenât declining meaning investment wouldnât continue. Krugman in his blog basically argues this. He states âMost spectacularly, IS-LM turns out to be very useful for thinking about extreme conditions like the present, in which private demand has fallen so far that the economy remains depressed even at a zero interest rate.â He sums up his argument for the liquidity trap and explains his logic behind the investment-savings, liquidity-money curve, and that is why he disagrees with Ferguson.

3. In the discussion, other discussants such as George Soros and Robin Wells pointed out some interesting issues. Please provide at least one thing that you agree and one thing that you disagree. Discuss in details why you think so.

Answer: One thing I found interesting was George Soroâs point in the debate in the New York review of books. He states âThe other feature is that the financial system collapsed of its own weight. That contradicted the prevailing view about financial markets, namely that they tend toward equilibrium, and that equilibrium is disturbed by extraneous forces, outside shocks. Those disturbances were supposed to occur in a random fashion. Markets were seen basically as self-correcting. That paradigm has proven to be false. So we are dealing not only with the collapse of a financial system, but also with the collapse of a worldview.â He continues to mention how Obama has 2 problems he has to face and how people who are viewing this crisis the same as the previous financial crisis, are making a huge mistake. To explain he states this: âBut when you have a collapse of credit thereâs only one source of credit that is still credible, and thatâs the state: the Federal Reserve and the Treasury. Then you have actually to inject a lot more leverage and money into the economy; you have to print money as fast as you can, expand the balance sheet of the Federal Reserve, increase the national debt. And that is, in fact, what has been done, which is the right thing to do. But then once this policy is successful, you have to rein in the money supply as fast as you can.â I think Soro is agreeing with Krugman and the monetary policy of pumping money into the economy. It will raise the money supply which eventually is left for us to capitalize on supply and let our GDP. Now I find this interesting because he is also agreeing with Krugmanâs IS-LM model, and later on, we come to find out that even Ferguson had come to an agreement with Krugmanâs points, with the exception being that the United States was a powerhouse, and therefore the European Union would eventually see its downfall.

Please make comments to the answer of discussion I provided above(at least 300 words total). And you can start with "I agree with you on some points... But I disagree with you on some points".

1. The primary tool used by supply-side economists to eliminate macroeconomic problems is

A. the discount rate.

B. corporate tax rates.

C. government spending.

D. open market operations.

E. the reserve requirement.

2. When the Federal Reserve System buys government securities on the open market,

A. the money supply will decrease.

B. excess reserves at commercial banks will decrease.

C. excess reserves at commercial banks will increase.

D. interest rates will increase

3. One of the advantages of automatic stabilizers over discretionary fiscal policy is that automatic stabilizers

A. has a greater multiplier effect than discretionary policy.

B. is not subject to the time lag problems of discretionary policy.

C. does not produce a deficit during recessions as a discretionary policy does.

D. makes the actual budget a better reflection of the condition of the economy than the full-employment budget.

4. "I have promised to do everything in my power to reduce the federal deficit. That means reducing federal expenditures and, if necessary, increasing taxes. Under present conditions of full employment and steady prices, we can afford to bear the burden of this debt (i.e., pay off the debt) now instead of passing it on to our children and grandchildren."

If the policies of the Senator quoted above were adopted, what effects would be expected while these policies were being implemented?

A. higher inflation

B. increases imports

C. higher rates of economic growth

D. increased unemployment and idle capacity

5. An inflationary gap can be reduced or completely closed by

A. decreasing taxes while leaving government spending on goods and services unchanged.

B. decreasing government spending on goods and services while leaving taxes unchanged.

C. increasing government spending on goods and services while leaving taxes unchanged.

D. increasing both government spending on goods and services and taxes by the same amount.

6. Compared to fiscal policy, an advantage of monetary policy is its

A. greater flexibility.

B. highly selective impact on segments of the economy.

C. ability to eliminate cost-push inflation.

D. need for approval by Congress.

E. need for approval by the President.

7. An increase in government spending on goods and services which causes a budget deficit to exist

A. is always inflationary.

B. is more inflationary than equal increases in private spending.

C. is usually not inflationary when the economy is operating at its full-employment level of output.

D. will not necessarily cause serious inflation as long as there are unemployed resources in the economy.

8. Some analysts believe the tax cuts enacted during the President H.W. Bush administration represented a supply-side economic policy rather than a Keynesian fiscal policy because

A. the tax cuts were accompanied by decreases in interest rates.

B. the tax cuts were accompanied by increases in government spending.

C. the tax cuts were primarily aimed at upper-income groups and businesses.

D. the tax cuts were primarily aimed at middle income and lower-income groups.

9. When the federal government is stabilizing the economy by increasing taxes, monetary authorities should

A. take actions to decrease interest rates.

B. increase the supply of money.

C. buy government securities in the open market.

D. follow an expansionary money policy.

E. follow a contractionary money policy.

10. Suppose a commercial bank has demand deposits (checking accounts) of $400,000, actual reserves of $170,000, and a reserve requirement of 20%. This single commercial bank can lend a maximum of ______ and the banking system can increase loans by a maximum of ______

A. $90,000 and $450,000.
B. $90,000 and $360,000.
C. $90,000 and $170,000.
D. $170,000 and $450,000.

E. both can lend an unlimited amount.

11. Which of the following would most likely result if the federal government increased its spending without changing tax revenues during a period of full employment?

A. inflation

B. a recession

C. lower interest rates

D. a larger net exports deficit

12. Fiscal policy that emphasizes cutting taxes as a means of improving incentives to work, and invest would be characterized in aggregate demand - aggregate supply framework primarily a shift

A. left in the aggregate demand curve.

B. left in the aggregate supply curve.

C. right in the aggregate supply curve.

D. no shift in either the aggregate demand curve or the aggregate supply curve.

13. Which of the following will result in the greatest increase in aggregate expenditures/demand?

A. A $100 decrease in personal income taxes

B. A $100 increase in personal income taxes

C. A $100 increase in government expenditures

D. A $100 increase in government expenditures which is accompanied by a $100 increase in personal income taxes

E. Both A and C will have the same effect on aggregate expenditures

14. You are given the following information about aggregate demand for an economy: (1)consumption = $600 billion; (2) investment = $50 billion; (3) government purchases = $100 billion; and (4) net export = $20 billion. If the full-employment level of GDP for this economy is $720 billion, then what combination of actions would be most consistent to achieve full employment and stable prices?

A. an increase in government spending and taxes

B. decrease government spending and taxes

C. decrease government spending and increase taxes

D. increase government spending and decrease taxes

15. Advocates of fiscal policy agree that discretionary fiscal policy will stabilize the business cycle most when the federal government

A. continuously incurs budget deficits.

B. continuously runs budget surpluses.

C. balances its budget every year.

D. incurs budget deficits during recessions and budget surpluses during demand-pull inflations.

E. incurs budget surpluses during recessions and budget deficits during demand-pull inflations.

16. Discretionary fiscal policy that increases the government budget deficit has the same effect on equilibrium as

A. an increase in personal saving.

B. an increase in business investment.

C. a decrease in government spending.

D. a decrease in personal consumption expenditures

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ECON 101 Lecture Notes - Lecture 8: Capital Accumulation, Income Tax, Loanable Funds

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