Question

Dentify each of the following events as:

a) part of an expansionary fiscal policy
b) part of a contractionary fiscal policy
c) part of an expansionary monetary policy
d) part of a contractionary monetary policy

i. The corporate income tax rate is increased.
ii. Defense spending is increased.
iii. Families are allowed to deduct all daycare expenses from their federal income taxes.
iv. The individual income tax rate is decreased.
v. The Federal Reserve Bank buys Treasury securities.

Assume the Federal government runs a budget deficit in the current fiscal year.
i. How can the Federal government fund the deficit?
ii. If the Federal government decides to issue U.S. Treasury securities to fund the deficit, what happens to the level of national debt, all else held constant?
iii. Assuming the Federal government and firms compete for the same savers’ dollars in the loanable funds market, what is likely to happen to interest rates?
iv. Given your answer in (iii) above, is crowding out more or less likely to occur if the deficit is funded by Treasury securities? Explain.

Answer 1

PART 1

Part of a contractionary fiscal policy

(i)The corporate income tax rate is increased

Part of an expansionary fiscal policy

(ii) Defense spending is increased

(Iii) Families are allowed to deduct all daycare expenses from their federal income taxes

(iv) The individual income tax rate is decreased

Part of a contractionary monetary policy

(v) The Federal Reserve Bank buys Treasury securities

PART 2

(i) Government can finance her budget deficit by three of the following ways which are:

Borrowing from either internal or external sources

Increasing taxes

Printing of more currency notes

(ii) National debt will increase by the percentage of the total treasury coupon value issued.

(iii) Crowding out this occurs when government increases her borrowing rate, which eventually leads to a substantial rises in the real interest rate, this also has an impact of consuming the economy's lending capacity and of discouraging private businesses from borrowing and making capital investments because of the high interest rise rate caused by the borrowing rate of government.

(iv)

Crowding out is more likely to occur too if budget deficit is finance by issuing Treasury securities, this is because treasury securities a have more investment security and profitable too and it has the capacity to mop up money in circulation leading to low interest savings rate and thereby reducing amount of money available for lending, which in turn increases the lending rate.