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By the end of this section, you will be able to:

  • Understand how fiscal policy and monetary policy are interconnected
  • Explain the three lag times that often occur when solving economic problems.
  • Identify the legal and political challenges of responding to an economic problem.

In the early 1960s, many leading economists believed that the problem of the business cycle, and the swings between cyclical unemployment and inflation, were a thing of the past. On the cover of its December 31, 1965, issue, Time magazine, then the premier news magazine in the United States, ran a picture of John Maynard Keynes , and the story inside identified Keynesian theories as “the prime influence on the world’s economies.” The article reported that policymakers have “used Keynesian principles not only to avoid the violent [business] cycles of prewar days but to produce phenomenal economic growth and to achieve remarkably stable prices.”

This happy consensus, however, did not last. The U.S. economy suffered one recession from December 1969 to November 1970, a deeper recession from November 1973 to March 1975, and then double-dip recessions from January to June 1980 and from July 1981 to November 1982. At various times, inflation and unemployment both soared. Clearly, the problems of macroeconomic policy had not been completely solved. As economists began to consider what had gone wrong, they identified a number of issues that make discretionary fiscal policy more difficult than it had seemed in the rosy optimism of the mid-1960s.

Fiscal policy and interest rates

Because fiscal policy affects the quantity that the government borrows in financial capital markets , it not only affects aggregate demand—it can also affect interest rates. In [link] , the original equilibrium (E 0 ) in the financial capital market occurs at a quantity of $800 billion and an interest rate of 6%. However, an increase in government budget deficits shifts the demand for financial capital from D 0 to D 1 . The new equilibrium (E 1 ) occurs at a quantity of $900 billion and an interest rate of 7%.

A consensus estimate based on a number of studies is that an increase in budget deficits (or a fall in budget surplus) by 1% of GDP will cause an increase of 0.5–1.0% in the long-term interest rate.

Fiscal policy and interest rates

The graph shows two demand curves that each intersect with a supply curve. Demand curve (D sub 0) intersects with supply curve (S) at E sub 0 (point $800, 6%). Demand curve (D sub 1) intersects with supply curve (S) at E sub 1 (point $900, 7%).
When a government borrows money in the financial capital market, it causes a shift in the demand for financial capital from D 0 to D 1 . As the equilibrium moves from E 0 to E 1 , the equilibrium interest rate rises from 6% to 7% in this example. In this way, an expansionary fiscal policy intended to shift aggregate demand to the right can also lead to a higher interest rate, which has the effect of shifting aggregate demand back to the left.

A problem arises here. An expansionary fiscal policy, with tax cuts or spending increases, is intended to increase aggregate demand. If an expansionary fiscal policy also causes higher interest rates, then firms and households are discouraged from borrowing and spending (as occurs with tight monetary policy), thus reducing aggregate demand. Even if the direct effect of expansionary fiscal policy on increasing demand is not totally offset by lower aggregate demand from higher interest rates, fiscal policy can end up being less powerful than was originally expected. This is referred to as crowding out    , where government borrowing and spending results in higher interest rates, which reduces business investment and household consumption.

Questions & Answers

where we get a research paper on Nano chemistry....?
Maira Reply
nanopartical of organic/inorganic / physical chemistry , pdf / thesis / review
Ali
what are the products of Nano chemistry?
Maira Reply
There are lots of products of nano chemistry... Like nano coatings.....carbon fiber.. And lots of others..
learn
Even nanotechnology is pretty much all about chemistry... Its the chemistry on quantum or atomic level
learn
Google
da
no nanotechnology is also a part of physics and maths it requires angle formulas and some pressure regarding concepts
Bhagvanji
hey
Giriraj
Preparation and Applications of Nanomaterial for Drug Delivery
Hafiz Reply
revolt
da
Application of nanotechnology in medicine
what is variations in raman spectra for nanomaterials
Jyoti Reply
I only see partial conversation and what's the question here!
Crow Reply
what about nanotechnology for water purification
RAW Reply
please someone correct me if I'm wrong but I think one can use nanoparticles, specially silver nanoparticles for water treatment.
Damian
yes that's correct
Professor
I think
Professor
Nasa has use it in the 60's, copper as water purification in the moon travel.
Alexandre
nanocopper obvius
Alexandre
what is the stm
Brian Reply
is there industrial application of fullrenes. What is the method to prepare fullrene on large scale.?
Rafiq
industrial application...? mmm I think on the medical side as drug carrier, but you should go deeper on your research, I may be wrong
Damian
How we are making nano material?
LITNING Reply
what is a peer
LITNING Reply
What is meant by 'nano scale'?
LITNING Reply
What is STMs full form?
LITNING
scanning tunneling microscope
Sahil
how nano science is used for hydrophobicity
Santosh
Do u think that Graphene and Fullrene fiber can be used to make Air Plane body structure the lightest and strongest. Rafiq
Rafiq
what is differents between GO and RGO?
Mahi
what is simplest way to understand the applications of nano robots used to detect the cancer affected cell of human body.? How this robot is carried to required site of body cell.? what will be the carrier material and how can be detected that correct delivery of drug is done Rafiq
Rafiq
if virus is killing to make ARTIFICIAL DNA OF GRAPHENE FOR KILLED THE VIRUS .THIS IS OUR ASSUMPTION
Anam
analytical skills graphene is prepared to kill any type viruses .
Anam
Any one who tell me about Preparation and application of Nanomaterial for drug Delivery
Hafiz
what is Nano technology ?
Bob Reply
write examples of Nano molecule?
Bob
The nanotechnology is as new science, to scale nanometric
brayan
nanotechnology is the study, desing, synthesis, manipulation and application of materials and functional systems through control of matter at nanoscale
Damian
Is there any normative that regulates the use of silver nanoparticles?
Damian Reply
what king of growth are you checking .?
Renato
What fields keep nano created devices from performing or assimulating ? Magnetic fields ? Are do they assimilate ?
Stoney Reply
why we need to study biomolecules, molecular biology in nanotechnology?
Adin Reply
?
Kyle
yes I'm doing my masters in nanotechnology, we are being studying all these domains as well..
Adin
why?
Adin
what school?
Kyle
biomolecules are e building blocks of every organics and inorganic materials.
Joe
how did you get the value of 2000N.What calculations are needed to arrive at it
Smarajit Reply
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Good
Equilibrium price is a stable price and it must stay.discuss
Elvis Reply
Card 14 / 21: What are the similarities between a consumer’s budget constraint and society’s production possibilities frontier, not just graphically but analytically?
Ali Reply

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Source:  OpenStax, Principles of macroeconomics for ap® courses. OpenStax CNX. Aug 24, 2015 Download for free at http://legacy.cnx.org/content/col11864/1.2
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