ScenarioBudget Deficit Expansionary Fiscal/ [ UNIT V ] Monetary and Fiscal Policy Interactions Fiscal policy has long internal lag and short external lag. Monetary policy has short internal lag and long/indeterminate external lag. The BIG IDEA is that fiscal and monetary policy have opposite effects on interest rates that leads to crowdingout/crowding in [The Arguments for Crowding Out]:  Crowding out is an unintended consequence of expansionary fiscal policy. For simplicity’s sake, assume that each of the following scenarios follows:     AD   G PL (P1-P2) rGDP (Y1-Y*) E (Y1-FE) UE (Y1-FE)           (A)  In order to purchase the new greater quantity (Y*) at the new higher prices (P2), there is an increase in the transactions demand for money. PL (P1-P2) MD r , r I , I AD rGDP (Y1-Y*) (the increase in r leads to E (Y1-FE) a decrease in the quantity UE (Y1-FE) of interest sensitive investment demanded) The final position of AD is between AD 1 and AD2. MD           r , r I , I AD (the increase in r leads to a decrease in the quantity of interest sensitive investment demanded) The final position of AD is between AD1 and AD2. PL (P1-P2) rGDP (Y1-Y*) E (Y1-FE) UE (Y1-FE) (A) DLF  AD  I  ,  I  r  ,  r   DLF     G deficit Financing  OUR WAY  2 MD  (B)     [ rGDP = RNI ] rGDP RNI  1    MD PL (P2-P3) rGDP (Y1-Y*)  E (Y* - Y3) UE (Y* - Y3)  (the increase in r leads to a decrease in the quantity of interest sensitive investment demanded) The final position of AD is between AD 1 and AD2. THE “TRUTH ” AD PL (P1-P2) rGDP (Y1-Y*) E (Y1-FE) UE (Y1-FE)   I  ,  I  r  ,  r       SLF (the increase in r leads to a decrease in the quantity of interest sensitive investment demanded) The final position of AD is between AD 1 and AD2.  SLF G deficit Financing  2  (B)  [Crowding Out]: (cont.) The monetary authority/central bank/FED is monitoring the economy and will sometimes act to prevent the unintended consequences of fiscal policy through what is called accommodating or reinforcing monetary policy. Essentially, this means enacting a monetary policy to minimize the interest rate effect of the fiscal policy in question.   AD   G   Crowding in is an unintended consequence of contractionary fiscal policy.  ScenarioBudget SurplusContractionary Fiscal/ [Crowding In: Our Way] PL (P1-P2) rGDP (Y1-Y*) E (Y1-FE) UE (Y1-FE) (A)  (the decrease in r leads to a increase in the quantity of interest sensitive investment demanded) The final position of AD is between AD 1 and AD2.   AD  I  ,  I  r  ,  r   DLF     G deficit Financing  DLF OUR WAY  2 PL (P1-P2) rGDP (Y1-Y*) E (Y1-FE) UE (Y1-FE)       The “Crowding In” scenario is listed as a matter of symmetry for our Crowding Out discussion. Any government activity that induces (mal)investment from the private sector could result in a Crowding In scenario. We prefer the symmetrical scenario detailed above for simplicity’s sake where victory > truth. Mankiw discusses the effects when the government intervenes in the market in such a way that result in an increase in private-sector investment, mainly on fixed inputs (capital, such as a factory). This occurs because government spending increases the demand for goods and services ( G AD), which results in higher business optimism (when business see that more people are buying their products, they are more optimistic about producing more of that product), and the demand for new output sources by businesses (capital is a source of output; it makes stuff; stuff is output) increases. New output sources are demanded because people are buying more stuff (due to government spending), and to meet this new demand, businesses need to invest (buy) the stuff that makes the goods and services that people are willing to pay for. Businesses are buying capital (stuff that makes stuff), which is an increase in investment ( I). This idea is different from crowding out, which states that expansionary fiscal policy ( G) results in a decrease in investment. Crowding in states that expansionary fiscal policy ( G) results in an increase in investment. The BIG Picture of Fiscal/Monetary Policy   UE E r G       Tincome       crowding potential Tcorporate       G       Tincome       Tcorporate          out  EXPANSIONARY rGDP EXPANSIONARY CONTRACTIONARY PL OMO buy       discount rate       accommodating reserve requirement       CONTRACTIONARY OMO sale       discount rate       reserve requirement          potential  MONETARY POLICY FISCAL POLICY AD monetary policy