Fiscal Policy, Crowding out, Supply-side, Economics
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
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
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