1. Policy Lags and
Crowding-Out Effect

2. Objectives
• Explain inside and outside lags for monetary and
fiscal policy.
• Define the crowding-out
• Explain the effects of crowding-out within the shortrun AD and AS model.
• Demonstrate the use of monetary policy to lessen or
reinforce the crowding-out effect.

3. Introduction
• Here, we discuss the lags associated with monetary
and fiscal policy making and analyze the direct and
indirect effects of government budget deficits.
• The direct effect of these deficits is an increase in
interest rates.
• When the government borrows money to finance its
deficit, this results in an increase in the demand for
money, or, alternatively, the demand for loanable
funds. This in turn results in an increase in the
interest rate.

4. • A higher interest rate causes decreases in
investment and other interest sensitive
components of AD.
• Crowding-out is the decrease in private
demand for funds that occurs when the
government’s demand for funds causes the
interest rate to rise:
– The demand by government for loanable funds
decreases or crowds-out the private demand for
loanable funds.

5. Lags Associated With Policy Making
• The inside lag consists of the time it takes for
data to be collected, policy makers to
recognize that policy action is necessary, the
decision about which policy should be taken
and the implementation of the policy.
• The outside lag is the time it takes the
economy to respond to the new policy. These
lags differ in length for monetary policy and
fiscal policy.

6. Monetary and Fiscal Policy
Tools of Monetary and Fiscal Policy
• Both monetary and fiscal policy can be used to
influence the inflation rate and real output.
Indicate what effect each specific policy has
on inflation and real output in the short-run (9
to 18 months).

7. Monetary Policy
1. (A) Buy government securities
(B) Sell government securities
2. (A) Decrease the repo rate
(B) Increase the repo rate
3. (A) Decrease reserve requirement
(B) Increase reserve requirement
Inflation
Real Output
Increase
Increase
Decrease
Decrease
Increase
Increase
Decrease
Decrease
Increase
Increase
Decrease
Decrease

8. Fiscal Policy
Inflation
Real Output
Increase
Increase
Decrease
Decrease
Decrease
Decrease
Increase
Increase
4. (A) Increase government spending
(B) Decrease government
spending
5. (A) Increase taxes
(B) Decrease taxes

9. Lags in Policy Making
• As the economic situation changes, policy
makers must decide when to take action and
what policy action to take. Then they must
implement the policy.
• The economy then responds to the policy.
The amount of time it takes policy makers to
recognize and take action is called inside-lags.
• The amount of time it takes the economy to
respond to the policy changes is called outside
or impact lags.

10. Crowding-Out: A Graphical Representation
• Sources of government borrowing:
– Treasury Bills
– Treasury Notes
– Treasury Bonds

11. • Government’s demand for funds increases the
demand for money.
Interest
Rate
MS
i1
i
MD1
MD
Money

12. Crowding-Out Using AD and AS Analysis
Nominal
Interest
Rate
PL
MS
SRAS
p
i
MD
AD
Y*
Real GDP
Quantity of
Money
1. Assume fiscal policy is expansionary and monetary policy
keeps the stock of money constant at MS. Shift one curve in
each graph to illustrate the effect of the fiscal policy.

13. Nominal
Interest Rate
PL
MS
SRAS
p1
p
AD1
i
MD
AD
Y*
A.
Y1
Real GDP
Quantity of Money
What happens as a result of this new curve?
Shift the AD curve to AD1, as a result of the expansionary fiscal
policy. The Price Levels and Y both increase

14. Nominal
Interest Rate
PL
MS
SRAS
p1
i1
p
AD1
MD1
MD
AD
Y*
Y1
i
Real GDP
Quantity of
Money
B. In the money market graph, shift the money demand curve
to demonstrate the effect of the fiscal policy. What happens
as a result of this shift?
Shift the MD curve to the right; money demand increased
because real GDP increased. Interest rate rises.

15. Nominal
Interest Rate
PL
MS
SRAS
p1
i1
p2
p
AD1
AD2
MD1
MD
AD
Y* Y2
C.
Y1
i
Real GDP
Quantity of
Money
Given the change in interest rates, what happens in the
short-run AS and AD graph?
AD shifts back to AD2 because the increase in interest rates
reduces some private domestic investment and interestsensitive consumer spending. This is crowding-out.

16. Nominal
Interest Rate
PL
MS
MS1
SRAS
p1
i1
p2
p
AD1
AD2
MD1
MD
AD
Y* Y2
D.
Y1
i
Real GDP
Quantity of
Money
How could a monetary policy action prevent the changes in interest rates and output you
identified in (B) and (C)? Shift a curve in the money market graph, and explain how this
shift would reduce crowding-out.
Shift the money supply curve to MS1. If the money supply is increased to MS1,
interest rates would move back to i. If interest rates are at i, there would be no
crowding-out (or reduction) of investment spending, and the AD would be AD1.

17. Applications:
Answer the questions that follow each of the
scenarios below.
1. The RBI Open Market Committee wishes to
accommodate or reinforce a contractionary
fiscal policy.
A. Would the RBI buy bonds, sell bonds or neither?
Sell bonds
A. What effect would this policy have on bond prices
and interest rates?
Bond prices would decrease, and the interest rate would
increase.

18. C. What effect would this policy have on bank
reserves and the money supply?
Bank reserves would decrease, and the money
supply would decrease.
D. What effect would this policy have on the
quantity of loanable funds demanded by the
private sector?
The bond sale would decrease the supply of loanable
funds; the increase in the interest rate would decrease
the quantity demanded of loanable funds (movement
along the demand curve).

19. E. What effect would the change in interest
rates you identified in (B) have on aggregate
demand?
AD would decrease because the higher
interest rates would curtail the interestsensitive components of consumption and
investment.

20. 2. The RBI Open Market Committee wishes to
accommodate or reinforce an expansionary
fiscal policy.
A. Would the RBI buy bonds, sell bonds or
neither?
Buy bonds.
B. What effect would this policy have on bond
prices and interest rates?
The price of bonds would increase, and the
interest rate would decrease.

21. C. What effect would this policy have on bank
reserves and the money supply?
Bank Reserves would increase and the
money supply would increase.
D. What effect would this policy have on the
quantity of loanable funds demanded by the
private sector?
The quantity demanded of loanable funds
would increase.

22. E. What effect would the change in interest
rates you identified in (B) have on AD?
AD would increase because of the lower
interest rates and the resulting increase in
interest-sensitive components of
consumption and investment.