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October 2
,
2009

ECONOMICS 302: INTER
MEDIATE MACROECONOMI
C THEORY

Discussion Section #4
:
Crowding Out

Consider the
IS
-
LM model from last week's discussion, we had the following result:

The IS curve:

The LM curve:

The equilibrium income

where

-
LM model handouts for detailed derivations.

Exercise 1:

Referring to previous discussion handouts:

C
onsider government increases government spending
by

(a) How much is

going to be changed

by
?

is going to be changed by the same amount as
.

(b) How much is the initial change in equilibrium income
?

Refer to the notes on multipliers.

October 2
,
2009

ECONOMICS 302: INTER
MEDIATE MACROECONOMI
C THEORY

(c) Illustrate the change graphically. (You should also try to work out the shift

of IS curve through the Keynesian
cross)

Exercise 2:

Consider the situation that we started from an initial budget surplus of zero. When government
spending is increased from
to
, the budget deficit widens. Suppose the government decided to
finance the deficit
by selling bonds
.

(a)
Explain what would happen in the bond market

if bond demand rises dollar for dollar with wealth

(graphically)

Government will issue bonds to financ
e the budget deficit, thus the bond supply will increase.
For every one unit
increase in wealth, bond demand will increase by one unit.
Wealth is the aggregate of money and bond, since
October 2
,
2009

ECONOMICS 302: INTER
MEDIATE MACROECONOMI
C THEORY

money supply remains constant and bond supply increases
, bond demand
will increase by the same amount,
leaving interested unchanged.

(b)
Consider money demand as a function of wealth, explain what will happen in the money market and the bond
market, and therefore, the effect on the LM curve.

The new money demand function:

The LM curve will shift up:

(c)
Explain how the fiscal policy (increasing government spending) can be linked with the changes in the financial
sector of the economy?

Supp
ose initially we had a budget deficit of zero,

When government spending increases, BuD is going to increase, the following relationship holds:

(All the deficit will be financed through the issuance of

government bonds.)

(d)
What is the final equilibrium income in this case?

The new equilibrium income can be obtained from

(e) What is the size government spending multiplier in this case? Compare with
?

October 2
,
2009

ECONOMICS 302: INTER
MEDIATE MACROECONOMI
C THEORY

(f) Explain the process graphically.

October 2
,
2009

ECONOMICS 302: INTER
MEDIATE MACROECONOMI
C THEORY

Exercise 3

Differences between portfolio crowding out and transaction crowding out.

Transaction crowding out:

Reduction in investment and net export as a result of higher interest rates caused by higher government
spending. It will depend on the size of
. The larger the size of interest sensitivity of investment and net
export, the larger

the transaction crowding out effect.

Portfolio crowding out:

Higher government spending (in the absence of a fully offsetting increase in tax revenues) is associated with
higher bond sales, hence higher wealth, and hence higher demand for money which, giv
en the fixed money
supply, results in higher interest rates for all income levels. Portfolio not only depends on
, it also
depends on j
--

large j indicates as wealth goes up, households want to hold more of their incremental in wealth in
the form of money and
the larger the crowding out effect.

Past Exam Questions:

6
.

Transactions crowding out of income is smaller:

a) the smaller the interest sensitivity of money demand

b) the smaller proportion of wealth people desire to hold as bonds

c) the smaller the income sensitivity of money demand

d) the smaller the interest sensitivity of investment

e) c and d above

(e
)

10. In the IS
-
LM model, changes in government purchases lead to larger changes in GDP if

a) money demand becomes less sensitive to GDP.

b) money demand becomes less sensitive to the interest rate.

c) they are offset by increases in

taxes.

d) the LM curve becomes steeper.

e) none of the above.