Economics Assignment #2
Question I. Fiscal Policy and the Crowding Out Effect.
(a) What is the essence of the accounting identity (the so called saving investment identity) that the two distinguished professors refer to?
Saving investment identity is a concept in National Income accounting that states that the amount saved (S) in an economy is equal to the amount invested (I). It is an equilibrium expressed in terms of supply (S), and demand (I), for lending (loan-able funds). Sp (Private Saving) + Sg or (T-G) (Government Saving or Budget Balance) = I. The authors are assuming full employment, where S=I.
The saving “identity” where S=I holds true by definition but it’s complexity is that this does not mean that an increase in savings will automatically increase investment. The relationship is more complex. As discussed in class, to bring S and I in line, the composition of other elements of the economy change when S or I change.
(b) Define the concept of “crowding out”. How does the identity in part (a), as claimed by the authors, explain the concept of crowding out and hence in their opinion vitiate fiscal policy?
Basically the “crowding out effect” is when government spending increases, increasing aggregate demand, but supply doesn’t change, government saving decreases, they finance by borrowing, issuing bonds, the government borrows more and the private sector borrows less, ultimately leading to less investment and a rising interest rate. The saving curve shifts to the left because of the rising interest rate. The authors are assuming full employment, as this is the only case where S=I. They are basically saying that the effect of expansionary fiscal policy is that it creates a deficit, and government spending increases ultimately make investments decrease by an equal amount essentially doing nothing, (because @ full employment you can’t change the supply side). Also money available for borrowing is finite, the government stepping in leaves less for everyone else, the cost of borrowing for the private sector increases, interest rate rises, and all of it leads to less investment in the economy. This they argue impairs the validity of fiscal policy.
(c) Drawing a diagram, as presented in basic Economics textbook in terms of the elements of the above identity, show that an increase in G (government spending) does not reduce (I) one for one.
(See diagram below)
Y full emp. = C + I + G
In FE, government increase by 1 = Investment decrease by 1.
An increase in government spending pushes S up significantly, interest rate will increase ( ), Investment will decrease ( ). This is the 100% crowding out effect. This is generally not the case in the majority of economies.
As mentioned, the degree to which the crowding out effect occurs depends the economy’s closeness to full employment. If at full employment and the government changes fiscal policy to increase government spending, (100% crowding out effect) it creates competition for resources, which increases interest rates, which leads to investment reduction.
BUT the 2008 financial crisis the economy has been BELOW full employment. We are not @ full employment. Increase in government spending actually makes GDP increase. As seen in the equation: Y = C + I + G. This will increase savings, because as GDP increases, disposable income increases, Yd. Therefore since Yd = C + Sp, savings increases.
Government increase by 1 = Investment decrease by less than 1. This is < 100% crowding out effect.
The saving curve shifts left because Private Saving and overall saving increase ( ), and then it shifts right ( ) (but not all the way) because GDP increases and then Investment increases. It shifts twice! (As seen by the arrows in the diagram)
Therefore S decreases, but not all the way. Interest rate rises but not as high as FE, and...
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