Suppose government spending increases in a closed economy. Would the effect on aggregate demand be larger if the Bank of Canada took no action in response, or if the Bank were committed to maintaining a fixed interest rate? Explain
I presume you are from Canada.
Larger under b) the bank is committed to maintaining a fixed interest rate.
Use a IS/LM curve analysis. An increase in G shift outward the IS curve, Which, by its self, increase aggregate demand and interest rates. To maintain a constant r, the Bank increases the money supply which shifts outward the LM curve.
no
To determine whether the effect on aggregate demand would be larger if the Bank of Canada took no action or if it were committed to maintaining a fixed interest rate, we need to analyze the different channels through which government spending affects aggregate demand and how the Bank's actions could influence these channels.
When government spending increases, it directly affects aggregate demand. This is known as fiscal policy. The increased government spending leads to higher aggregate demand because it injects more money into the economy, stimulating consumption and investment.
If the Bank of Canada took no action, it means that monetary policy remains unchanged. In this case, the interest rates would be determined by market forces. An increase in government spending without any change in interest rates could lead to an increase in demand for goods and services. However, it might also lead to upward pressure on interest rates due to the increased demand for credit, as the demand for investment and borrowing increases. Higher interest rates could reduce private consumption and investment, partially offsetting the positive impact of government spending on aggregate demand. Therefore, the effect of government spending on aggregate demand in this scenario would be larger, but the magnitude of the increase would depend on the responsiveness of private sector spending to changes in interest rates.
On the other hand, if the Bank of Canada were committed to maintaining a fixed interest rate, it would actively intervene in the money market to ensure that interest rates do not change in response to the increase in government spending. This is known as monetary policy. By keeping interest rates fixed, the Bank aims to provide stability and predictability in the financial markets. In this scenario, the impact of government spending on aggregate demand would be more certain and direct, as there would be no increase in interest rates to potentially reduce private sector spending. Therefore, the effect of government spending on aggregate demand in this scenario would be larger compared to when the Bank of Canada took no action.
In summary, if the Bank of Canada took no action, the effect of government spending on aggregate demand would be larger but potentially offset to some extent by higher interest rates. If the Bank were committed to maintaining a fixed interest rate, the effect of government spending on aggregate demand would be larger and more direct, without the potential offset from higher interest rates.