Question

If the US economy is doing well, both the Fed and the government may pursue tighter fiscal and monetary policies. What are the objectives of such a policy mix? How might a tighter fiscal and monetary policy mix be implemented? Will crowding out be a problem? Explain why or why not

Answer 1

Answer:

The objectives of tighter fiscal and monetary policies:

When the economy is growing at a very faster rate, at that time the need arises for Fed and Government to tighten the monetary policy and fiscal policy respectively. The major objectives are as under:

• To reduce inflation in the economy
• To control money supply in the market
• To reduce government spending
• To increase government revenue
• To stabilize overall economy

A tighter fiscal and monetary policy mix can be implemented by the following ways:

• To increase short-term interest rates: this way discount rates will be higher so now borrowing would be costlier than previous rates. Higher interest rates become no more attractive.
• To increase the tax rates and to reduce government spending so that people have less income to spend which results in less consumption.

Crowding out be a problem? Yes.

Why:

• Crowding out means “the reduction in aggregate demand that results when a fiscal expansion raised the interest rate is called the crowding-out effect.”
• Due to tight policy mix of monetary policy and fiscal policy in the economy aggregate demand is reduced with higher interest rates and increase in government spending. As a result, there is reduction in the personal consumption and private sector investment in the economy. This will reduce aggregate demand in the economy. So the problem of crowding out will arise.