--%>

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 : Monetary policy-how is it decided The

    The practice explores how monetary policy influences the economy and the type of factors which are significant in finding out the Monetary Policy Committee’s decision.

  • Q : Supply use two market diagrams to

    use two market diagrams to explain how an increase in state subsidies to public colleges might affect tuition and enrollments in both public and private colleges?

  • Q : Analyzing number of event that

    How can we analyze the number of event that influences the market?

  • Q : Why is tax not a capital receipt

    Illustrate, why is tax not a capital receipt?

  • Q : Tariffs Tariffs: -are also called

    Tariffs: -are also called import quotas. -may be imposed either to raise revenue (revenue tariffs) or to shield domestic producers from foreign competition (protective tariffs). -are per unit subsidies designed to promote exports. -are excise taxes on goods exported abroad.

  • Q : Net revenue when price increases Net

    Net revenue for Macho Man fake mustaches increases after the price raised from $5 to $7, pointing that demand faced by Macho Man was: (i) Relatively elastic. (ii) Relatively inelastic. (iii) Unitarily elastic. (iv) Perfectly inelastic. (v) Perfectly e

  • Q : Custodian of nations foreign exchange

    Name the institution that acts as a custodian of nation’s foreign exchange reserves? Answer: The Central Bank is an institution that acts as custodian of natio

  • Q : Competitive market What do you mean by

    What do you mean by the term Competitive market?

  • Q : Problem onto marginal tax rates A

    A prosperous person who made higher and higher incomes yearly would possibly benefit most from: (w) proportional tax system. (x) progressive tax system, much like the one in place today. (y) regressive tax system. (z) fixed percentage tax system.

    Q : Sources of demand for foreign currency

    State main sources of demand for foreign currency? Answer: The four main sources of demand for foreign currency are as follows: A) To buy services and goods from other countries. B) To send a gift abroad.