(35 points total) We discussed the idea of crowding out and why it occurs. In this problem we are considering…

1. (35 points total) We discussed the idea of crowding out and why it occurs. In this problem we are considering two scenarios: Scenario 1: G rises and the Fed does not accommodate the shock to money demand. Scenario 2: G rises and the Fed accommodates the shock to money demand, as they would if they were committed to the zero bound.

(10 points for each correct and completely labeled diagram). Draw three diagrams side by side. On the left, draw a consumption function, in the middle, draw a money market diagram, and on the right, draw an investment demand function.  Locate the initial equilibrium as point A, labeling the relevant values using subscript A as in the level of consumption at point A as CA, the level of interest rates as iA, etc.

Scenario 1: G rises, no accommodation by the Fed, locate the new equilibrium as point B on all three diagrams, being sure to label your diagrams completely. Show and explain the crowding out that Barro discusses in the “Government Spending is no Free Lunch” article.  In particular, we are assuming total crowding so that Y does not change, along with the assumption of a closed economy. Be sure to explicitly identify the crowding out on the consumption function and investment demand functions that you drew above.

As G rises GDP or Y rises so that we move along the Consumption curve (shown in red). The demand for transactions rises so that money demand shifts to right. This causes r to rise from rA to rB. This rise reduced I from IA to IB. This is the traditional crowding out effect. As per Barro the decline in I and other components can equal the rise in G causing Y to remain unchanged. This is seen as a shift of I curve inwards. This shows that even if r rises due to higher demand for money balances, investment declines (shown by I) Y will decline to cause C to decline again, so that we reach old level of Y, making the multiplier 0. Scenario 2: G rises, the fed completely accommodates the shock to money demand so that interest rates remain unchanged (identical to the Romer assumption). Show this development as point C on all three diagrams.

(5 points) In the Romer paper, the multipliers that they use assume that the Fed will keep interest rates constant for the foreseeable future. Referring to your diagrams, does this assumption increase/decrease/ or have no effect on the estimated spending multiplier? Explain.