Macroeconomic Policy Analysis: IS-LM & Fiscal Impact

Macroeconomic Policy Analysis: Corrientes

True, False, or Uncertain: Economic Concepts

1.1 IS-LM Model: Fiscal Policy Effectiveness

In the context of the IS-LM income determination model, an expansionary fiscal policy based on an increase in spending will be more effective (i.e., expand output more) to the extent that the real money demand is less sensitive to the level of output. (15 pts.)

Answer to 1.1

True

The less sensitive the demand for money is to income, the less the expansion of the transaction component of money demand. Given this, the excess money demand caused by fiscal policy will be comparatively lower, implying a more moderate increase in interest rates. Interest rates will rise less, making the crowding-out effect smaller and the expansionary fiscal policy more effective.

1.2 Self-Financing Policy & Production Effects

A self-financing policy, where spending and taxes increase by the same magnitude, will not generate production effects. Consider a closed economy analysis and identify the assumptions used. (15 pts.)

Answer to 1.2

False

The effect will be expansive. It must be remembered that the spending multiplier is higher than the tax multiplier (in absolute value). This occurs because the marginal propensity to consumption ranges between zero and one.

1.3 Fiscal Policy & Credit Crunch in Closed Economy

In the case of a closed economy, and in a context of financial crisis (freezing of credit), explain why the adoption of an accommodative fiscal policy can deepen the credit crunch. (15 pts.)

Answer to 1.3

This occurs because an expansionary fiscal policy raises interest rates (due to the excess demand for liquidity generated). When rates rise, credit becomes more expensive and scarce.

1.4 Fisher Effect, Deflation & Recession Probability

In class, we reviewed the Fisher effect, which established the difference between real and nominal interest rates. Based on the Fisher equation and using class knowledge, explain why a scenario where inflation is consistently negative (and consistently falls below expectations) is consistent with a high probability of recession. (15 pts.)

Answer to 1.4

The Fisher Equation states:

Nominal Interest Rate = Real Interest Rate + Expected Inflation

If expected inflation is systematically negative (and surprising), the ex ante interest rate applied to loans will be higher than the ex post rate that actually occurs when the loan matures. This means borrowers end up paying a higher real interest rate than anticipated, increasing the real burden of debt and discouraging investment and consumption, which can lead to or deepen a recession.