With the general equilibrium framework in place, the stage is now set for introducing fiscal and monetary changes and analysing their effects on the general equilibrium. We will first introduce a fiscal change in the form of increase in deficit-financed expenditure, and then introduce a discretionary increase in money supply, and look into their effect on the equilibrium rate of interest and the income level. Finally, we will analyse the combined effects of the simultaneous fiscal and monetary changes.
Effect of fiscal changes in general equilibrium framework
The effect of change in government spending on the national income, ?Y = ?G X G-multiplier . But, in the general equilibrium framework, the result is significantly different. Why? This is the issue of this section. To begin with, recall the analysis of increase in deficit financed ?G of $100 bullion on the product market equilibrium. We gave shown there how a ?G causes shift in the IS curve. Here, we discuss the effect of ?G of $100 billion on the general equilibrium. We know that ?G causes and upward shift in the is curve and, thereby, a rise in the equilibrium income. The new IS-function can be estimated as follows.
The demand side of the product market equilibrium equation reads as
I + G + ?G = 200 - 2000i + 100 = 300 - 2000i
And supply side, in our example, reads as S +T = - 100 + 0.4Y . Recall also that by using these equations, we can derive a new IS schedule with ?G = 100 . The process is reproduced below.
I + G + ?G = S + T
300 - 2000i = - 100 + 0.4Y
Y = 1000 - 5000i
The ISt schedule intersects the LM0 schedule at point B note that pre-?G equilibrium was at point A. the shift in the equilibrium point from A to B, shows that, with ?G = $100 billion and no change I money supply, the equilibrium level of income increases form $475 billion to $600 billion and interest rate rises to 8%.
This can also be proved algebraically given the ISt schedule in and LM0 schedule as Y = 200 + 5000 I, , the product and money market equilibrium equation can be written as,
1000-5000i = 200 + 5000i
I = 0.08 or 8%
By substitution 0.08 for I , we get the equilibrium Y as
Y = 1000 - 5000 (0.08)
Y = 600 billion
It is important to note here that an increase in the government spending increases both the rate of interest and the level of income. If is more important to note that ?Y < ?G X G - multiplier . This is so because of what economists call crowding-out effect of public expenditure.