Question

Given the following (All variables are in present dollars):

C = 120 + 0.6(Y-T)

I = 50 + 0.2Y - 2000i

G = 250

T = 200

Md = P(2Y - 8000i)

M = 1600

P = 1

a. If the investment equation in the economy I = 50 + 0.2Y, would monetary or fiscal policy be more effective as a stabilization tool?

b. If the demand for money in this economy were Md= P(2Y), would monetary or fiscal policy be more effective as a stabilization tool?

c. What would be a policy plan that would increase national savings without changing the level of GDP?

Answer 1

a) Given I = 50 + 0.2Y, fiscal policy would be more effective as a stabilization tool as fiscal policy would affect investment and aggregate demand through the channel of output spending. Since in this equation, I is not dependent on i (interest rate) monetary policy would not be as effective because monetary policy works through interest rate channel.

b) Given  Md= P(2Y), the nominal demand for money is dependent on the level of nominal output and thus fiscal policy would be a better tool for stabilization.

c) A rise in interest rates would encourage investment and savings, while discouraging consumer spending. Overall, the level of GDP will remain constant if these two effects offset each other.