NAME : NURUL ALIA BINTI ABDUL RAZALI
MATRIC NO : EIA1610161
Explain the effect of an expansionary fiscal policy in the classical model when it is done through the following method;
Expansionary fiscal policy involves the government seeking to increase the aggregate demand (AD) through higher government spending and lower tax. Usually, it is financed by increasing the government borrowing and selling bonds to the private sector.
An increase in government borrowing.
Initially, the market equilibrium is at point E where supply of loanable funds (SS) equal to demand of loanable funds (DD). At that point, the interest rate at ro and saving (S0) equal to investment (I0).
As borrowing increases, the government have to pay more interest rate payments to those who hold bonds. If government borrows from the supply of loanable funds (SS) which is available from workers, it increases the demand for such funds and forces interest rates up where the demand for loanable funds (DD) shift to the right from I0 to I+(G-T). At the higher interest rate which is r1, people will consume less so consumption (C) declines while return on saving (S) increases and the supply of loanable funds (SS) increases from S0 = I0 to S1 = I + (G-T). At interest rate (r1), supply of loanable funds (SS) is increases to the point F. The higher the interest rate (r) , the lower the borrowing by firms for investment purposes. The government borrowing ‘crowds out’ private borrowing where at r1 private investment decreases from I0 to I1.
An increase in government spending (G) where the government borrowing is increase matches the decreased in private consumption (C) and investment (I).
An increase in money supply.
Initially, the labor market equilibrium is when labor supply (Ns) is equal to labor demand (Nd) at point E. At that point, employment at N0, output at Y0 and price at P0.
When money supply (Ms) is increases, it will shift the aggregate demand (AD) to the right from AD0 to AD1. At point Y0. Money supply (Ms) does not have effect on Y because output is fixed.
When the agregate demand (AD) is increase, aggregate demand (AD) is greater than aggregate supply (AS). So, there is excess demand of goods. When people demanded for goods is high, while the output is fixed at Y0, the price (P) will increase from P0 to P1 due to high demand of goods. Money supply has no effect at total output because output is fixed.
The reduction on the marginal tax rate.
By increasing the disposable income of households, a tax cut would stimulate consumption. If however, the government sold bonds to the public to replace the revenue lost by the tax cut, the same crowding out process would foow, as in the case of a bond financedincreasein government spending. The quilibrium interest rate would rise, investment would fall,and there would al,so be an interest rate induced rise in saving (S), meaning that consumption would fall back toward the pre tax cut level. In the case of tax cut , as with an increase in spending, aggregate demand would not be affected.
If revenue lost because of the tax cut were replaced by printing new money, then as with an increase in government spending money creation would increase AD and the tax cutwoud cause the price leve to rise. Increase in money supply that affected the price eve.
A reduction in the marginal tax rate increases the real wage (W/P. The labor supply (NS) curve shifts to the right from NS0 to NS1. . Equilibrium moves from point E to F. Employment and output increase, moving from E to F on the production function. This increases in output is represented by the shifts to the right in the vertical agreagate supply curve in c.
In the classical model, such a change would have an incentive effect on labor supply (NS). The change would effect the supply side and affect the output and employment.
Labor market increase labor supply, at any value of real wage (W/P) and shift the labor supply to the right from NS0 to NS1. Equilibrium employment increase from NOto N1. Increase in employment will increase in labor supply and also increase in output.