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Evaluate the effects on income and the rate of interest of a decision to meet the government's budget constraint by way of (a) an increase in taxes (b) a rise in monetary supply (c) increased bonds sales.

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1. Evaluate the effects on income and the rate of interest of a decision to meet the government's budget constraint by way of (a) an increase in taxes (b) a rise in monetary supply (c) increased bonds sales Lecture notes 06/11/03 SMG 206... Plan: Intro. Budget Constraint: - Simply means that all g'ment expenditure must be financed; it is not a restraint on spending, but a recognition of need always to meet the financing requirement. Diagram of Budget constraint, can be covered in 3 ways. Effects on Y & r of ? taxes Effects on Y & r of ? monetary supply Effects on Y & r of ? Bond sales Conclusion (including evaluation of effective methods) G ?, IS shifts out. G'ment outlay curve moves down Income and r increase Gap between G & T represents Budget deficit which must be covered. Three ways to cover this budget deficit: a) ...read more.


b: - ? Monetary Supply by equivalent amount of increase in G As before, IS and Government outlay curve move together, but now there is also a shift in the LM curve. This reinforces the expansionary effect of the increase in G. It is partly due to this conclusion that the monetarists claim that fiscally oriented policies will exert a minor impact unless they are accompanied by accommodating changes in the money supply. At new equilibrium Y is higher than in standard cases, but interest rate much lower. This is the second most expansionary policy of the 3. c: - Increase in bond sales to the private sector by equivalent amount to increase in government spending. Debt finance: A rise in the quantity of debt payments means more interest paid out to the public. Two effects: - 1 Increase in disposable income- induces a rise in consumption and hence further shift right of IS curve. ...read more.


However, it could cause problems due to the increase in interest rate. This position rests fundamentally upon three assumptions which are seldom explicitly specified: 1) All requisite bonds can be sold. There is no limit to the extent to which the authorities can sell government bonds. This does not have universal application. In many of the less advanced economics, for example, the absence of confidence in the government of the day virtually prohibits this method of finance. 2) Public do not equate bonds to taxes (Ricardo-Barro Equivalence). 3) The resultant bond sales generate wealth effects. Whether bonds issued by the central government constitute net wealth from the viewpoint of the private sector is altogether a different issue and one which has generated considerable controversy. If fiscal (sell more bonds) and monetary policy (increase money supply) were used together simultaneously, then expansion would take place without the problem of making the interest rate too unstable. We must remember to consider shapes and positions of IS and LM curves. ...read more.

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