Consider a closed economy where investment is sensitive to the interest rate. Is fiscal expansion more effective in affecting the level of real income? Explain.
In a closed economy where investment is sensitive to the interest rate, fiscal expansion can be more effective in affecting the level of real income.
Fiscal expansion refers to an increase in government spending or a decrease in taxes, aimed at stimulating economic growth. When investment is sensitive to the interest rate, it means that changes in the interest rate have a significant impact on investment decisions by businesses.
With fiscal expansion, the government increases its spending on infrastructure projects, education, healthcare, or other sectors. This increase in government spending directly stimulates the demand for goods and services in the economy. As a result, businesses experience an increase in demand for their products, leading to higher production levels and potentially expanding their operations.
When businesses see an increase in demand and have the expectation of growing markets, they are more likely to engage in investment activities, such as expanding their facilities, purchasing new machinery, or employing more workers. However, their investment decisions are influenced by the cost of borrowing, which is determined by the interest rate.
In a fiscal expansion scenario, the government often needs to finance its increased spending through borrowing. As the government increases its borrowing, it puts upward pressure on interest rates. Higher interest rates make borrowing more expensive for businesses. This can discourage businesses from borrowing for investment purposes, potentially offsetting the positive impact of fiscal expansion on investment.
However, if investment is sensitive to the interest rate, it means that even with higher interest rates, businesses may still find it favorable to borrow for investment purposes. This sensitivity to the interest rate implies that businesses prioritize the expected return on their investment over the cost of borrowing.
Therefore, in a closed economy where investment is sensitive to the interest rate, fiscal expansion can be more effective in affecting the level of real income. The increase in government spending stimulates overall demand, leading to higher production levels and potentially encouraging businesses to invest in expanding their operations. Despite the impact of higher interest rates on borrowing costs, businesses may still find it advantageous to make investment decisions based on the expected return on their investments.
In a closed economy where investment is sensitive to the interest rate, fiscal expansion can have an effect on the level of real income. Here's the explanation step-by-step:
Step 1: Understand the basic concept
Fiscal expansion refers to an expansionary fiscal policy, where the government increases its spending or reduces taxes to stimulate economic growth. The level of real income represents the total value of goods and services produced in the economy.
Step 2: Relationship between fiscal expansion and investment
When the government engages in fiscal expansion, it increases its spending, which can lead to increased demand for goods and services. This increased demand can, in turn, create more business opportunities and incentives for investment.
Step 3: Interest rate effect on investment
Investment is sensitive to the interest rate because it affects the cost of borrowing for businesses. When interest rates are high, borrowing costs increase and businesses may be less likely to invest in new projects. Conversely, when interest rates are low, the cost of borrowing decreases, making investment more attractive.
Step 4: Impact of fiscal expansion on interest rates
Fiscal expansion typically leads to an increase in government spending, which can result in higher borrowing needs. To finance this increased spending, the government may issue more bonds. This increased supply of bonds can put upward pressure on interest rates.
Step 5: Overall impact on real income
The impact of fiscal expansion on real income depends on the relative magnitudes of the effects mentioned above. If the increase in government spending and the subsequent increase in investment outweigh the impact of higher interest rates, then fiscal expansion can be effective in stimulating the level of real income.
Step 6: Conclusion
In a closed economy where investment is sensitive to the interest rate, fiscal expansion can be effective in affecting the level of real income. However, the overall impact depends on the interplay between government spending, investment decisions, and interest rates.