Archive for November, 2012

Nov 21 2012

IB Economics Podcast Assignment – Market Failure Commentary

As IB SL and HL students, you will be required to write, record and post one podcast written and performed by you and a classmate. The purpose of this project will be to strengthen and enhance your ability to explain economic theory, apply it to current real-world issues and evaluate the effectiveness of economic theory to explain what is occurring.As these skills are required to write a successful IB Economic Internal Assessment, the process of producing the podcasts will strengthen the performance of students on their IAs.

Before reading the rest of the assignment details, listen to the three podcasts below. The first is an introduction to the IB Internal Assessment and this podcast assignment from Mr. Hauet. The second is an example of the type of analysis you may do in an IB Economics podcast from me. The third is a podcast by a Digital Journalism student in which she investigates the negative externalities of the meat industry.

The Assignment:

Students will work in pairs and sign up to produce a podcast on a real world market failure.

For example, you may choose to do your story on an industry you are aware of that creates water pollution:

  • Research the industry and find examples how it creates water pollution.
  • Investigate the external costs imposed by this industry on the environment and human health.
  • Gather data from studies that have already been conducted on industry’s contributions to water pollution.
  • Interview individuals or find others’ written or audio/visual accounts of the social, environmental, or health impacts of water pollution.
  • Investigate solutions to water pollution that have been implemented in different communities or nations.
  • Propose solutions to the specific examples of water pollution you have investigated.

Any audio editing program may be used to produce your podcast. You may find the following recommendations useful:

Podcast Requirements:
Part 1 – Introduction
  • An intro accompanied by music – the intro should be a hook such as a section from an interview or a clip from a news program. The music should not be copyrighted and therefore must be taken from sites such as Jamendo or produced by yourself (Garage Band is great for this)
  • An brief  introduction to the topic of the podcast
  • A fact, economic indicator or story that happened recently that may interest your listeners.This is your “hook”.
Part 2 – Analysis
  • Summarize the issue. This should include the cause of the market failure, what it means for the economy, the environment, society or human health, and what is being done about it.
  • Application – How can economic theory inform our understanding of the market failure you have chosen to research.
  • Analysis– Does economic theory support the findings from your research and what is said in the interview? Why or why not? In a written commentary, diagrams would be a crucial part of analysis. Since this is audio, you can describe the concepts that the diagram you could use illustrate.
  • Interview – The podcast must include at least one interview with someone who can provide additional insight into the market you have chosen to research. You may interview someone yourself, or you may use an excerpt from an interview you found in your research (perhaps on YouTube).

Part 3 – Evaluation

  • Evaluation – What are the short and long run implications of the market failure on society, the environment or human health. What are the possible solutions to your market failure? How are different stakeholders effected? Is one solution better than another and why?
  • Conclusions – Bring the podcast to a close by discussing the implications of the issue in other areas. Can this issue be fixed and if so what are the future implications? Be sure to end just as you started, with some nice music that suits the topic.

Bibliography: As this assignment will involve original research, you are required to produce a bibliography. It should be formatted properly. You may use EasyBib to help you with the formatting of our bibliography.

Examples:

Here are some examples of economics podcasts from Planet Money. Your podcast should be similar in its production to these.

Samples of last year’s student podcasts:

Your final product will be assessed using similar criteria for the internal assessment and will include the following:

  1. Terminology – Terminology appropriate to the topic is used throughout the podcast – 2 marks
  2. Application – Relevant economic theories are applied throughout the podcast – 2 marks
  3. Analysis – There is effective economic analysis within the context of the topic and interview – 3 marks
  4. Evaluation – Judgments are made using sound evidence and appropriate reasoning – 4 marks
  5. Podcast Requirements – The podcast is presented in a highly effective manner, including a clear introduction with music, clear audio, at least one interview, a conclusion with music, and a bibliography formatted in MLA style. – 3 marks

Total – 14 marks

2 responses so far

Nov 15 2012

Advice for writing a strong IB Economics Internal Assessment on Macroeconomics

My IB year 2 students are in the process of writing their second Internal Assessment commentary (IA), a major component of their grade in the course. Last spring they wrote a commentary on a microeconomic topic, and this time around they are investigating macroeconomic issues to write about. I thought I’d write a quick post to offer some advice for conducting a solid commentary on a macroeconomic topic.

First of all, it should be pointed out that finding a good article to write a macro commentary on should be very easy. Pretty much any newspaper (print or digital) is bound to have a couple of macro-related stories on its front page any day of the week. The tricky part, however, is choosing an article on a topic that interests you, the student. One place to start to look for the perfect article is on the Welker’s Wikinomics Universe page, which includes over 40 live streams from different economics news sources. You can be sure that the articles you find here are current and that the sources have already been filtered by an experienced Econ teacher, so they can generally be considered appropriate. 

WARNING: Make very sure that the article you are considering is NOT a blog post, a commentary or an editorial piece. It is strongly discouraged to write a commentary on another person’s commentary. One way to determine whether an article is a commentary is to look at the URL and if you see words like “blog” or “commentary” or “editorial”, or “opinion”, you should move on to another article.

I recommend my students choose an article about their own home country. This way, they have at least some vested interest in the issues they’re writing about.

Now, how to choose a good article. Below are some of the main themes in Macroeconomics that could serve as outstanding main ideas of an IB Economics commentary:

Economic growth:  The media is obsessed with GDP growth rates, perhaps because society seems to be equally obsessed. Any article about growth (or the opposite of growth, recession), can provide you with lots of points for analysis and evaluation.

  • What are the sources of growth or recession?
  • Who are the winners and losers?
  • What is the government doing to promote growth (or reduce the chance of inflation)?
  • What are the short-run and long-run implications of economic growth for society?
  • Does growth really make us better off?
  • Is growth sustainable?

The tradeoff between inflation and unemploymentThis relationship is best illustrated in the Phillips Curve model. It’s easy to find evidence of this tradeoff in the press, as inflation and unemployment are just behind GDP as the macroeconomic indicators most mentioned in the news.

  • Why is there a tradeoff between these two indicators?
  • What is the relationship between AD/AS and the Phillips Curve
  • When should unemployment be the primary concern of policymakers? When should inflation be the primary concern?
  • What are the effects of inflation on different stakeholders?
  • What are the effects of unemployment on society?
  • How can monetary and/or fiscal policy be used to reduce unemployment OR inflation, but not both?
  • How could supply-side policies be used to bring down both inflation and unemployment?
  • How might negative supply-shocks affect the SRAS and the short-run Phillips Curve?
  • Does the tradeoff between these two indicators hold up in the long-run? Why or why not?

Income inequality: This is perhaps one of the MOST talked about economic topics in the news today. Rising Gini indexes in most developed economies indicate that inequality is growing, and this may be contributing to political and social discontent in the rich world.

  • What are the sources of income inequality?
  • What are the consequences of income inequality? (Economic, social, short-run and long-run)
  • How does inequality affect economic growth? (positively or negatively?)
  • How have government policies in a particular country contributed to growing inequality?
  • How does the free market promote income inequality? (In other words, is it a market failure?)
  •  How can a nation’s tax code and system of social safety nets be used to reduce income inequality?
  • What is the difference between equality and equity?

Fiscal policies: This is a big one. With America’s “fiscal cliff” all over the news and the European debt crisis fresh on people’s minds, it is hard not to find articles about fiscal policy today.

  • How have past fiscal decisions by government contributed to the growing levels of debt in Europe and America today?
  • What role to automatic stabilizers in fiscal policy have in dampening the effects of fluctuations in aggregate demand (either inflationary or recessionary effects)?
  • How does the theory of the Keynesian spending multiplier provide an argument for the use of expansionary fiscal policy during recessions?
  • How does the theory of the crowding-out effect provide opponents of the Keynesian view with an argument against the use of expansionary fiscal policy? (Why might government deficits lead to less private sector spending).
  • What role can fiscal policy play in the short-run and in the long-run in promoting or inhibiting economic growth?
  • What types of fiscal policies (particularly government spending) will best promote long-run economic growth?

Monetary policies: It’s really easy to find news articles in which central banks are mentioned. Whether it’s the “Fed” in the United States, the ECB in Europe, the People’s Bank of China, the Banke of England or the Indian National Bank, central banks are the masters of monetary policy, and the media follows their every move closely.

  • What are the tools of monetary policy and how can it be used to stimulate or contract demand in an economy?
  • When is monetary policy likely to be most effective at reducing unemployment?
  • When is monetary policy likely to be most effective at reducing inflation?
  • Why might a central bank’s primary objective (low inflation) conflict with the macroeconomic objectives of government (low unemployment)?
  • How can monetary policy be used to support a government fiscal policies?
  • What is the risk associated with continually increasing the supply of money in a nation?

Supply-side policies: “Austerity” is a word heard often in Europe today. The fear over large budget deficits has led several European governments to reduce government expenditures drastically on public goods and social spending. This is having major impacts on the quality of life in many European countries, and leading to unrest (and even riots) in some cases.

  • What is the short-run effect of deficit reduction on aggregate demand?
  • What is the argument for deficit reduction? How might such policies help an economy “self-correct” during periods of recession?
  • How will smaller budget deficits lead to lower interest rates in the economy?
  • How does reducing expenditures on transfer payments to the unemployed and poor in the economy promote more flexible labor markets?
  • How might the de-regulation of industry and lower business taxes promote investments that lead to long-run economic growth?
  • How does the supply-sider’s view of the macroeconomy differ from the Keynesian’s view? Which view is more valid?

The ideas above only scratch the surface of the potential areas of investigation a student could pursue in a Macroeconomics commentary. There is one model that ALL macro commentaries should employ, however, and that is the Aggregate Demand / Aggregate Supply model. Nearly every topic in this section of the course requires AD/AS analysis. Otherwise, there are several other models that could be used depending on what specific topic you are investigating. These are:

  • AD/AS
  • Phillips Curve (both short-run and long-run)
  • Lorenz Curve and Gini index (for income inequality)
  • The Laffer Curve (for income inequality or supply-side policy)
  • The Money Market diagram (for monetary policy)
  • The loanable funds market (for fiscal policy)
  • Bond market diagrams (for fiscal policy)

Have you already written a strong commentary on a macro topic? Would you like to your ideas about the assignment? Please post your own thoughts on this assignment below. If you have published your own commentary, feel free to post a link for others to see it!

36 responses so far

Nov 09 2012

Economic arguments for and against a carbon tax

Reuters – Long-shot carbon tax suddenly part of fiscal cliff debate

The article above suggests that during Barack Obama’s second term as president of the United States, the country may begin to seriously consider imposing a tax on carbon dioxide emissions. The justification for such a tax, points out the article, is two-fold:

The aftermath of Superstorm Sandy, which devastated parts of the U.S. East Coast last week, has raised fresh questions about the links between climate change and extreme weather events, which also makes the idea of a carbon tax more appealing.

A carbon tax is a mechanism to charge emitters of greenhouse gases, such as power plants and oil refiners, for each ton of carbon dioxide they emit.

Prospects for such a tax as a way to address pollution and climate are probably dim in a still deeply-divided Congress, but some analysts say the measure would be more attractive if positioned as a source of new revenue.

In fact, a recent report by the Congressional Research Service, suggesting a $20 per ton tax on carbon emissions could halve the U.S. budget deficit over time.

Such a tax would generate about $88 billion in 2012, rising to $144 billion by 2020, the report said, slashing U.S. debt by between 12 and 50 percent within a decade, depending on how high the deficit climbs, the report said.

America’s government budget has been in deficit every year since 2000, meaning the government spends more than it collects in taxes. Fears over the growing national debt and the impact it will have on future economic growth potential have led many in the US government to look for new ways to earn tax revenue for the government, even some ways that have bene considered taboo until now.

In my year 1 IB Economics course this week we have been learning about and evaluating taxes and subsidies in the markets for various goods. Generally, we learn that government intervention in free markets worsens the overall allocation of resources in the market economy, imposes more costs on society than benefits, and therefore leads to a loss of total welfare. For example, a tax on American beef in Switzerland helps keep the price of imported meat high, benefiting Swiss farmers, but overall the higher price of meet and the reduced quantity and variety available to consumers harms many in society to the benefit of the few cattle farmers. Such a tax, it can be argued, creates a loss of total welfare in society, as the tax’s cost outweighs its benefit.

But not ALL indirect taxes (those placed on the production and consumption of particular goods) reduce total welfare in society. A tax on a good that is over-consumed by the free market may actually improve total welfare as the higher cost to producers leads to a reduced supply, higher price, and a reduction in the quantity demanded in the market. A cigarette tax is the classic example. Without taxes on cigarettes, more people would smoke, creating more harmful effects for society, such as the ills of second-hand smoke, higher rates of lung cancer, greater demand for health care and the higher prices that this increased demand create for all of society, even non-smokers. Cigarette taxes are so widely employed by government and accepted by society that there is no debate whatsoever about their use.

But taxes on other goods that create ills for society are highly controversial, and for good reason. Perhaps one of the most debated and divisive tax proposals of recent years has been on the emission of carbon dioxide, a greenhouse gas emitted during the burning of fossil fuels. The main emitters of CO2 in the United States are the country’s electricity generating firms, which burn coal, gas and oil more than any other industry in the country. CO2 emissions are measured in tons, and a CO2 tax would apply to each ton of the gas emitted by fossil fuel consuming firms.

Arguments against a carbon tax

The primary argument against a tax on CO2 emissions is that it would drive up the costs of energy production, leading to higher energy costs for the nation’s households and firms. This boost in prices would increase costs to producers of all other goods and services in the economy, effectively reducing the supply in several key sectors of the US economy, leading to falling national output, more inflation and greater unemployment. American industry would become less competitive with other nation’s producers, leading to more factories closing down and moving overseas, taking American jobs with them.

Such a conclusion requires that a CO2 tax would, in fact, lead to significant decreases in the amount of energy demanded by the nation’s households and firms. In other words, it assumes a relatively elastic demand for electricity. It also assumes that as the price of fossil fuel generated electricity rises, there will be few alternative forms of electricity for firms to switch to. This leads us to the arguments for a carbon tax.

Arguments for a carbon tax

Energy is an essential good that consumers (whether they be households or firms) demand in large quantities regardless of the price. A carbon tax, which increases the cost and decreases the supply of fossil fuel energy, will not significantly reduce the amount of fossil fuel energy consumed in the United States; at least not in the short run, during which there will be very few substitutes for fossil fuel energy available to consumers.

However, one outcome that proponents of the tax hope for is an increase in the demand for alternative energies, such as wind and solar, which do not require the burning of fossil fuels. Such alternatives are not currently price-competitive with fossil fuels, but a carbon tax would make them more competitive, increasing demand for alternative energies and leading to a greater percentage of America’s total energy production coming from wind and solar.

The graphs below show the desired outcome of a CO2 tax on the markets for fossil fuel energy and renewable energies.

Notice that the tax does not lead to a significant decrease in the quantity of fossil fuel energy consumed in the short run. Businesses in the US will face higher costs, but energy costs are a relatively small proportion of most US industries’ total costs. (The biggest cost faced by US firms, not surprisingly, is labor costs). But the highly inelastic demand assures that fossil fuel energy prices will rise, leading to greater interest from consumers in alternative energies. In the graph on the right, we see an increase in the demand for renewables, leading to a greater quantity being produced.

But what might the long-run impact of a carbon tax be on the US energy sector? As we can see in the graph on the right above, greater demand for renewables will drive their prices up, which over time will increase the appeal of renewable energies to the country’s electricity producing giants. Slowly, the number of renewable energy producers will grow, as old coal or gas burning electricity plants are decommissioned and new wind or solar plants are installed. The supply of renewable energies should rise while the supply of fossil fuel energy should decrease. The result is an ever growing percentage of America’s total energy production generated using wind, solar, or other renewable sources of power. The graphs below show the possible long run impact of a carbon tax in the fossil fuel and renewable energy sectors.

Here we can see that in the long-run, the prices of renewable energies and fossil fuel energies will become closer as the supply of energy produced using wind and solar grows, making it more price-competitive and therefore reducing the demand for fossil fuel energies.Presumably, if the outcomes described above come to pass, the proposed carbon tax could lead to meaningful reductions in America’s greenhouse gas emissions over the long run, as the composition of the nation’s energy production slowly transitions away from non-renewable fossil fuels to renewable, non-polluting energy sources.

But what about the other reason the government is considering a carbon tax now? Remember those fears over the national debt and deficit? How effective would a carbon tax be at raising revenue to help the government balance its budget? To determine this, we must look again at the first graph we drew, only examine the impact of the tax on government, not just the market for fossil fuel energy.

In the graph above, we see that the tax creates a large chunk of tax revenue for the government, “about $88 billion in 2012, rising to $144 billion by 2020”. These figures seem optimistic, especially if the previous outcome in which the demand for fossil fuel energies falls in the long run comes to pass. But for now, at least from this Economics teacher’s perspective, a tax on carbon is a good first step towards both reducing American’s dependence on fossil fuels and generating desperately needed government revenues.

26 responses so far

Nov 08 2012

Tax progressivity in the US: Do the rich pay more than their fair share? The evidence indicates NO!

Just How Progressive Is the Tax System? – Economix Blog – NYTimes.com

According to a blog post in the New York Times from April 2009, America’s America’s “progressive” tax system is not as progressive as many may believe it to be:

Research has found that many states and local governments have… regressive tax systems… that might offset the progressiveness of [US] federal tax rates.

The research from Citizens for Tax Justice — a liberal organization that advocates “fair taxes for middle and low-income families” — uses 2008 data for all federal, state and local taxes combined. It found that the average effective tax rate is 29.8 percent, and that including state and local taxes makes the tax curve look much less steep:

In the graph above, the horizontal axis shows the income group. The vertical axis shows the percentage of income that the average member of that group pays in taxes. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

The article continues:

The group also finds that in 2008 the share of total federal, state and local taxes paid by each income group was relatively close to the share of income that that group brings in, at least as compared to comparable 2006 numbers for effective federal tax rates:

The horizontal axis shows the income group. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

The research discussed above poses several interesting questions about the make-up of a nation’s tax revenues. Despite popular belief, it appears that the rich in America do not pay “more than their fair share”, as many argue is the case. Study the graphs carefully, and answer the questions that follow:

Discussion Questions:

  1. Based on the data above, do the rich in America pay an unfair proportion of the total taxes the US government collects? Why or why not?
  2. Why do the richest 5% in America actually pay a lower level of tax on average than the 5% below them?
  3. How much of America’s total income is earned by the richest 1% compared to the poorest 20%? Does America’s progressive tax system destroy the incentive for Americans to work hard and become rich? Why or why not?
  4. Use the data to construct a Lorenz Curve for the United States. Does the gap between the richest and the poorest Americans surprise you? What kinds of changes could be made to the tax system to narrow the gap between the top income earners and the middle and low income earners in America? Should this be done, why or why not?

131 responses so far

Nov 06 2012

A closer look at the crowding-out effect

To spend or not to spend. That is the question. In order to determine whether or not a government should increase its budget deficit in order to stimulate economic activity in its economy, it is important to determine whether said deficit spending will lead to a net increase in the nation’s GDP or a net decrease in GDP. Obviously, if increasing the debt to pay for a government spending package leads to lower aggregate demand in the economy, then it should not be undertaken. However, if a deficit-financed spending package leads to an overall increase in output and national income, it may be justified.

To understand the circumstances under which a government stimulus package will increase or decrease overall output in the economy, we must compare two competing possible impacts of a government stimulus. The multiplier effect of government spending refers to a theory which says that any increase in government spending will lead to further increases in private spending, as households enjoy more income and thus consume more and firms, which earn more revenues due to the government’s increased spending, make new capital investments, contributing to the stimulus provided by government and leading to an overall increase in GDP that exceeds the increase in government spending.
The crowding-out effect, on the other hand, refers to the theory that any increase in government spending, when financed by a larger deficit, will lead to a net decrease in private expenditures, as firms and households face higher interest rates due to the governments’ intervention in private financial markets. Government spending will crowd out private spending, thus any increase in spending will be off-set by a decrease in private spending, possibly even reducing overall income in the nation.
This post will focus on the second of these effects, and attempt to explain the circumstances under which crowding-out is likely to occur, and those under which it is unlikely to occur.
Deficit-financed government spending refers to any policy that increases government expenditures without increasing taxes, or one that reduces taxes without reducing government expenditures. In either case, a government must increase the amount of borrowing it does to pay for the policy, which means governments must borrow from the private sector by issuing new debt in the form of government bonds.
When a government must borrow to spend, it has to attract lenders somehow, which may require the government to offer higher rates of return on its bonds. The impact this has on the supply of private savings, which refers to the funds available in commercial banks for lending and borrowing in the private sector, will be negative. In other words, the supply of loanable funds in the private sector will decrease.
The graph below shows the market for loanable funds in a nation. The supply curve represents all households and other savers who put their money in private banks, in which they earn a certain interest rate on their savings. The demand for loanable funds represents private borrowers in the nation, who demand funds for investments in capital and technology (firms) and durable goods and real estate investments (households). The demand for loanable funds is inversely related to the real interest rate in the economy, since higher borrowing costs mean less demand for funds to pay for investment and consumption.
When a government needs to borrow money to pay for its deficit, private savers (represented by Slf above) will find lending money to the government more attractive than saving in private banks, since the relative interest rate on government bonds is likely to rise. This should reduce the supply of loanable funds in the private sector, making them more scarce and driving up borrowing costs to households and firms. This can be seen below:
In the illustration above, a government’s deficit spending crowds-out private spending, as firms and households find higher interest rates less attractive and thus demand less funds for investment and consumption. Private expenditures fall from Qe to Q1; therefore any increase in economic output resulting from the increase in government spending may be off-set by the fall in private spending. Crowding-out has occurred.
Another way to view the crowding-out effect is to think about the impact of increased government borrowing on the demand for loanable funds. Demand represents all borrowers in an economy: households, firms and the government. An increase in public debt requires the government to borrow funds from the private sector, so as the supply of loanable funds fall, the demand will also increase, although not from the private sector, rather from the government. The effect this has can be seen below:
 –
In the graph above, both the reduced supply of loanable funds resulting from private savers lending more to the government and the increased demand for loanable funds resulting form the government’s borrowing from the private sector combine to drive the equilibrium interest rate up to IR2. The private quantity demanded now falls from Qe to Qp, while the total amount of funds demanded (from the private sector and the government  now is only Qp+g. This illustration thus shows how an increase in government borrowing crowds out private spending but also leads to an overall decrease in the amount of investment in the economy.
Based on the two graphs above, a deficit-financed government spending package will definitely crowd-out private spending to some extent, and in the case of the second graph will even lead to a decrease in overall expenditures in the economy. This analysis could be used to argue against government spending as a way to stimulate economic activity. But this analysis makes some assumptions that may not always be true about a nation’s economy, namely that the equilibrium level of private investment demand and the supply of loanable funds occurs at a positive real interest rate. There are two possibilities that may mean the crowding-out effect does not occur. They are:
  • If the private demand for loanable funds is extraordinarily low, or
  • If the private supply of loanable funds is extraordinarily high.
When might these conditions be met? The answer is, during a deep recession. In a recession, household confidence is low, therefore private consumption is low and savings rates tend to rise, increasing the supply of funds in private banks. Also, firms’ expectations about the future tend to be weak, as low inflation or deflation make it unlikely that investments in new capital will provide high rates of return. Home sales are down and consumption of durable goods (which households often finance with borrowing) is depressed. Essentially, during a recession, private demand from borrowers is low and private supply from households is high. If the economy is weak enough, the loanable funds market may even exhibit an equilibrium interest rate that is negative. This could be shown as follows:
 –
 –
Notice that due to the exceedingly low demand and high supply of loanable funds, 0% acts as a price floor in the market. In other words, since interest rates cannot fall below 0%, there will be an excess supply of funds available to the private sector. Such a scenario is known as a liquidity trap. The level of private investment will be very low at only Qd. Banks cannot loan out all their excess reserves, and even though borrowing money is practically free, borrowers aren’t willing to take the risk to invest in capital or assets that may have negative rates of return, a prospect that is not unlikely during a recession.
So what happens when government deficit spends during a “liquidity trap”, as seen above? First of all, the government need not offer a very high rate to borrow in such an economy. Private interest rates will be close to zero, so even a 0.1% return on government bonds will attract lenders. So the supply of loanable funds may decrease, and demand may increase, but crowding-out will not occur because there is almost no private investment spending to crowd out! Here’s what happens:
 –
Here we see the same shifts in demand and supply for loanable funds as we saw in our first graph, except now there is no increase in the interest rate resulting from the government’s entrance into the market. Since private interest rates stay at 0%, the private quantity of funds demanded for investment remains the same (Qp), while the increased government borrowing leads to an increase in overall spending in the economy from Qp to Qp+g. Rather than crowding-out private spending, the increase in government spending has no impact on households and firms, and leads to a net increase in overall spending in the economy.
If the government spends its borrowed funds wisely, it is possible that private spending could be crowded-in, which means that the boost to total output resulting from the fiscal stimulus may increase firm and household confidence and shift the private demand for loanable funds outwards, increasing the level of private investment and consumption, further stimulating economic activity.
So what have we shown? We have seen that in a healthy economy, in which households and firms are eager to borrow money to finance their spending, and in which savings rates are not exceedingly high, government borrowing may drive up private interest rates and crowd-out private spending. But during a deep recession, in which consumer spending is depressed and firms are not investing due to uncertainty and savings rates are higher than what is historically normal, an increase in government spending financed by a deficit will have little or no impact on the level of private investment and consumption. In such a case, governments can borrow cheaply (at just above 0%), and increase the overall level of demand in the economy without harming the private sector.
Crowding-out is a valid economic theory, but its likelihood of occurring must be evaluated by considering the actual level of output and employment in the economy. In a deflationary setting, in which savings is high and private spending is low, government may have the opportunity to boost demand and stimulate growth without driving up borrowing costs in the private sector and decreasing the level of household and firm expenditures.

14 responses so far

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