Graphs for Ch’s 9-12 Fiscal Policy Test

Expansionary Fiscal Policy involves either an Increase in Government Spending, a Decrease in Taxes, or a combination of both. The effects on the Loanable Funds Market are shown in the following graphs Typically we use the Demand change.

Increase in the Demand for Loanable Funds SLF r1 r DLF 1 DLF QLF q q1 DLF  .: r% ↑ & QLF ↑

Contractionary Fiscal Policy involves either a Decrease in Government Spending, an Increase in Taxes, or a combination of both. The effects on the Loanable Funds Market are shown in the following graphs Typically we use the Demand change.

Decrease in the Demand for Loanable Funds SLF r r1 DLF DLF 1 QLF q1 q DLF  .: r% ↓ & QLF ↓

The Crowding Out Effects of Expansionary and Contractionary Fiscal Policies are shown in the graphs that follow:

Expansionary Fiscal Policy: Side-effect: “Crowding-out” Loanable Funds Market Investment SLF r% r% r1 r DLF 1 ID DLF IG q q1 QLF I1 I G↑ and/or T↓ .: Government deficit spends .: DLF  .: r%↑ .: IG↓ (Crowding-Out Effect)

Contractionary Fiscal Policy: Side-effect: “Crowding-In” Loanable Funds Market Investment SLF r% r% r r1 DLF 1 ID DLF IG q1 q QLF I I1 G ↓ and/or T ↑ .: Government moves toward budget surplus .: DLF .: r% ↓ .: IG ↑ (Crowding-In Effect)

Changes in Exchange Rates Exchange rates (e) are a function of the supply and demand for currency. An increase in the supply of a currency will decrease the exchange rate of a currency A decrease in supply of a currency will increase the exchange rate of a currency An increase in demand for a currency will increase the exchange rate of a currency A decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and Depreciation Appreciation of a currency occurs when the exchange rate of that currency increases (e↑) Depreciation of a currency occurs when the exchange rate of that currency decreases (e↓) Ex. If German tourists flock to America to go shopping, then the supply of Euros will increase and the demand for Dollars will increase. This will cause the Euro to depreciate and the dollar to appreciate.

for the British Pound relative to the U.S. Dollar Increase in the Demand for the British Pound relative to the U.S. Dollar $/£ S£ e1 e D£ 1 D£ Q£ q q1 D£  .: e ↑ & Q£ ↑ .: £ appreciates relative to the $

for Yen relative to the British Pound Decrease in the Demand for Yen relative to the British Pound £/¥ S¥ e e1 D¥ D¥ 1 Q¥ q1 q D¥  .: e ↓ & Q¥ ↓ .: ¥ depreciates relative to the £

Exchange Rate Determinant For Net Export Effect of Expansionary Fiscal Policy The main determinant here is the change in the real interest rate caused by Expansionary Fiscal Policy: Expansionary: For expansionary, the real interest rate will increase due to an increased demand for Loanable Funds by the Federal Government in order to deficit spend to fight recession. The graphs that follow show the effect of this policy on the Loanable Funds Market, AD/AS, and Foreign Exchange:

Increase in the Demand for Loanable Funds SLF r1 r DLF 1 DLF QLF q q1 DLF  .: r% ↑ & QLF ↑

On the following AD/AS graph, note that we begin with a Recessionary Gap

C↑, IG↑, G↑ and/or XN↑ .: AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑ Increase in AD SRAS LRAS PL  PLe  PLf AD1 AD  Ye YF GDPR C↑, IG↑, G↑ and/or XN↑ .: AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑

.: $ appreciates relative to the $ Market for U.S. Dollar £ /$ S£ e1 e D£ 1 D£ Q£ q q1 D$  .: e ↑ & Q$ ↑ .: $ appreciates relative to the $

Explanation of the Net Export Effect of Expansionary Fiscal Policy: 1) Explanation of the Net Export Effect of Expansionary Fiscal Policy: 1) With Expansionary Fiscal Policy, an increase in Government Spending and/or a decrease in Taxes, should increase the Demand for Loanable Funds (deficit spending), increase AD, and cause the U.S. Dollar to appreciate as foreign investors are attracted to the higher real interest rates on U.S. Government Securities (like bonds, as foreign investment money flows into the U.S., so the demand for the $ increases).

At the tail end of the cause and effect chain for Expansionary Fiscal Policy, US exports decline as our products become more expensive to the world, but imports increase, due to more buying power by Americans with the appreciation of the U.S. Dollar. 3. Therefore, since Xn is Exports minus Imports, Xn goes down. Since Xn is part of AD and GDPr, both AD and GDPr decline slightly, partially offsetting the Expansionary Fiscal Policy actions.

Exchange Rate Determinant For Net Export Effect of Contractionary Fiscal Policy The main determinant here is the change in the real interest rate caused by Contractionary Fiscal Policy: Contractionary: For contractionary, the real interest rate will decrease due to a decreased demand for Loanable Funds by the Federal Government in order to fight inflation. Here, the Federal Government will move toward a budget surplus. (toward, meaning we may still have a budget deficit overall). The graphs that follow show the effect of this policy on the Loanable Funds Market, AD/AS, and Foreign Exchange:

Decrease in the Demand for Loanable Funds SLF r r1 DLF DLF 1 QLF q1 q DLF  .: r% ↓ & QLF ↓

C↓, IG↓, G↓ and/or XN↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓ Decrease in AD LRAS PL SRAS  P  P1 AD AD1  YF Y GDPR C↓, IG↓, G↓ and/or XN↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓

.: $ depreciates relative to the £ Market for U.S. Dollar £/$ S¥ e e1 D¥ D¥ 1 Q¥ q1 q D$  .: e ↓ & Q$ ↓ .: $ depreciates relative to the £

Explanation of the Net Export Effect of Contractionary Fiscal Policy: 1) With Contractionary Fiscal Policy, a decrease in Government Spending and/or a increase in Taxes, should decrease the Demand for Loanable Funds (move toward budget surplus), decrease AD, and cause the U.S. Dollar to depreciate as foreign investors are not attracted to the lower real interest rates on U.S. Government Securities (like bonds, as foreign investment money doesn’t flow into the U.S., so the demand for the $ decreases).

At the tail end of the cause and effect chain for Contractionary Fiscal Policy, US exports increase as our products become more cheaper to the world, but imports decrease, due to lower buying power by Americans with the depreciation of the U.S. Dollar. 3. Therefore, since Xn is Exports minus Imports, Xn goes up. Since Xn is part of AD and GDPr, both AD and GDPr increase slightly, partially offsetting the Contractionary Fiscal Policy actions.