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.

Answer 1

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.