--%>

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 : Crisis in Japan & US Question: What can

    Question: What can we learn from the Japanese experience? Is the US headed for a 'lost decade? Answer: There was a similari

  • Q : Redistribution of Income through budget

    Redistribution of Income: Each and every economy strives to achieve a society, where inequality of income and wealth must be minimum. In order to attain this objective via government budget the government spends adequate money on social security schem

  • Q : Estimating rational income How will you

    How will you treat the given in estimating rational income of India? Provide reasons for your answer. (i) The value of bonus shares received by the shareholders of a company.(ii) Interest received on loan pro

  • Q : Steps to analyze modifications in

    What are the Steps to analyze modifications in equilibrium?

  • Q : The Fed can control the Fed funds rate

    Question: Hubbard argues that the Fed can control the Fed funds rate, but the interest rate that is important for the economy is a longer-term real rate of interest.   How much control does the Fed have o

  • Q : Price ratios and marginal utility ratios

    I have a problem in economics on Price ratios and marginal utility ratios. Please help me in the following question. The efficiency in consumption needs equality of: (i) Income distribution. (ii) All product price and resources. (iii) MC and MR. (iv)

  • Q : National income how to calculate

    how to calculate national income under value added method

  • Q : Export business prefer rising or

    Would export businesses choose a rising or declining dollar? Would it be similar for a European tourist on a budget and visiting the Grand Canyon? Explain your answer.

  • Q : Demand according to range of adjustments

    As longer time periods are taken and a bigger range of adjustments (or substitutions) become obtainable, then demand curves tend to become: (1) flatter, as supply curves become steeper. (2) Steeper as supply curves become flatter. (3) Flatter, and therefore do supply

  • Q : Inflation Inflation is frequently

    Inflation is frequently described as "too much money chasing too few goods." Is this a satisfactory definition?