--%>

Fiscal Monetary changes

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.

   Related Questions in Macroeconomics

  • Q : Maximum Consumer Surplus Assume that

    Assume that you receive $18 worth of ‘jollies’ (that is, utility, satisfaction or pleasure) from the very first hole of golf played on a particular day, and that your extra jollies from succeeding the holes drops $1 for each and every hole played. You shou

  • Q : Discount rate-Prime rate and the

    What is the difference among the discount rate, prime rate and the subprime rates of interest? Which interest rate in particular build the 2008 recession? Explain how that happened.

  • Q : Tax shifting forward totally A tax is

    A tax is shifted forward when the tax burden causes the: (w) consumers to pay higher prices. (x) lower purchasing power for the party bearing the legal incidence. (y) workers to experience lower take home wages. (z) decreased dividends to corporate st

  • Q : Plan and non-plan expenditure Write a

    Write a brief note on plan and non-plan expenditure of the government with illustration. Answer: Plan Expenditure

  • Q : Tax system problem In the figure shown

    In the figure shown below, line T1 depicts a tax system which is: (1) Regressive. (2) Progressive.  (3) Proportional. (4) Unbiased. (5) Recessive. 2471_7.jpg

  • Q : Receipts from taxes Why are receipts

    Why are receipts from taxes classified as revenue receipts? Answer: Receipts from taxes are classified as revenue receipts since they do not build liabilities nor r

  • Q : Difference between APC and MPC

    Differentiate between APC and MPC. The value of which of them can be greater than another and when? Answer: APC is the average

  • Q : Problem on production function Consider

    Consider a model economy with a production function Y = K0.2(EL)0.8, where K is capital stock, L is labor input, and Y is output. The savings rate (s), which is defined as

  • Q : Explain Tax rate increase. A change in

    A change in tax rate changes the IS equation, LM equation remaining the same. Let same, let us suppose that the government raises the tax rate from 20 percent to 25 percent<

  • Q : Economic Economic systems differ

    Economic systems differ according to which two main characteristics?