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ECON 209 Lecture Notes - Lecture 19: Business Cycle, Deficit Spending, Autarky

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maroonyak232
3 Apr 2016
School
McGill University
Department
Economics
Course
ECON 209
Professor
Paul Dickinson

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Document Summary

Lecture - march 29: national savings = private sector savings + public sector savings, withdraws = injections. Do deficits harm future generations: gov debt redistributes resources and consumption: away from future generations, Can formal fiscal rules prevent excessive build-up of debt: annually balanced budgets, would force discipline on governments but would leave to pro-cyclical. 2. fiscal policy in recessions would have to raise tax rates and reduce government spending to balance the budget > would accentuate the business cycle: cyclically balanced budget. Government must balance budget over the econ cycle - surpluses in booms pay for the deficits in recession. This is desirable in principle but difficult to define or implement. Political problems can be expected > does the government have the discipline not to increase g when t revenues are high in boom: allowing for growth. Gdp ratio is probably more important: another problem: formal fiscal rules emphasizes the budget deficit but the d/

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Related Questions

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.

Niall Ferguson believed that expansionary fiscal policy could produce a crowding-out effect. Ferguson believed that if the government tried to increase demand during the crisis it would cause the real interest rate to increase. He theorized that if the government tried to boost the economy through deficit spending it would cause the interest rate to rise, which in turn would crowd-out investors and consumers. The interest in the deficit would lead to an increase in the demand for loanable funds, which would lead to an increase in interest rates. Ferguson stated "The lesson of economic growth is very clear. Economic growth does not come from state-led infrastructure investment. It comes from technological innovation, and gains in productivity, and these things come from private sector, not from the state."

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 .

Paul Krugman disagreed with Ferguson and believed that the government deficit could not produce a crowding out effect. Krugman's liquidity trap: Private demand is so low that even if the short-term interest rate is 0% spending is less that what is needed for full employment. Normal monetary policy of the central bank purchasing short-term debts with new money is ineffective. Krugman argues that a major issue during the crisis was people wanting to save money combined with the private sector being far less likely to invest. He referred to this a "savings glut". It was argued that the federal reserve was playing the part that the private banking system through buying private securities and the federal government was playing the roll that business wasn't by engaging in investment. Due to the liquidity trap excess demand for savings is not going to drive interest rates up. Krugman stated " Government borrowing gives some of those excess saving a place to go and in the process expands overall demand, and hence GDP. It does not crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap."

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.

I agree with Soros view that the publics view of the financial markets has been forever changed. " Financial markets namely that they tend toward equilibrium, and that equilibrium is disturbed by extraneous forces, outside shocks. But the finical system collapsed of its own weight." I feel like this is a situation in which it takes a very long time to build trust, but that trust can be lost instantly. The crash has challenged the felling of security that people once felt in the banking system. The idea of the market regulating itself is fading, it wasn't until the government stepped that people felt reassured in the banking system. I believe this will lead to a period of government regulation that wouldn't have arose without this change in view. I disagree with robin Wells' view that the US needs to shift towards protectionism. I believe that free trade is good for everyone as long as there is a comparative advantage. If the US moves toward protections as a result of the deficit it will slow economic growth and place us at a disadvantage compared to countries with free trade. Not to mention consumers in the US will be placed with the burden of higher prices on goods.

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

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 nation’s spending amount which increases the economy’s 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. That’s 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 “you can’t be both a monetarist and a Keynesian simultaneously—at least I can’t 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.” 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 doesn’t 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 doesn’t 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 aren’t declining meaning investment wouldn’t continue. Krugman in his blog basically argues this. He states “Most 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.” 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 Soro’s point in the debate in the New York review of books. He states “The 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.” 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: “But when you have a collapse of credit there’s only one source of credit that is still credible, and that’s 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.” 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 Krugman’s IS-LM model, and later on, we come to find out that even Ferguson had come to an agreement with Krugman’s 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".

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 nation’s 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