Question

Suppose government spending increases. Would the effect on aggregate demand be larger if the Federal Reserve held the money supply constant in response or if the Fed were committed to maintaining a fixed interest rate? Explain.

Answer 1

When the government increases its spending, it leads to an increase in aggregate demand.

Now, if the Federal reserve keeps the money supply constant in response to the expansionary fiscal policy, the interest rates will rise and crowd out a part of the private investments. This means that the crowding out effect will lead to aggregate demand increasing less than the increase in government spending.

Further, if the Federal reserve keeps the interest rates constant in response to the expansionary fiscal policy, there is 0 crowding out. That means, the increase in expansionary fiscal policy will lead to an increase in aggregate demand by an amount greater than or equal to the increase in government spending.

Therefore, the effect on aggregate demand would be larger when the Fed maintained a fixed interest rate.