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Policy Debates

Problems

Problems with Monetary Policy and Fiscal policy

Budget Deficit

Problem : What is the link between monetary policy and real variables?

There is no actual link between monetary policy and real variables because the total level of output is determined by the factors of production and not by monetary variables.

Problem : How does each of the variables in the output equation react to the a rise in the interest rate?

Consumption tends to fall as the interest rate rises. Investment tends to fall as the interest rate rises. Government spending is relatively unaffected by changes in the interest rate. Net exports tend to rise as the interest rate rises.

Problem : What is the effect of expansionary monetary policy on the interest rate?

Expansionary monetary policy directly lowers the interest rate by making money easier and cheaper to obtain.

Problem : What is the effect of expansionary fiscal policy on the interest rate?

Expansionary fiscal policy increases the interest rate by decreasing the savings rate as more money is given to the government and the government spends more money.

Problem : What is meant by the term "crowding out"?

When the government increases spending, the interest rate rises, and investment falls. This is called crowding out. That is, increases in government spending tend to reduce, or crowd out, private investment.

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