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IAI Actuarial Core Principles · Business Economics · Impact of macroeconomic policies on businesses

A government pursues a fiscal expansion while the central bank keeps the money supply fixed. Under the standard IS-LM analysis with a fixed money supply, which statement about the effect on private investment is correct?

Private investment is partly crowded out. With a fixed money supply, higher income raises money demand and pushes interest rates up, which reduces interest-sensitive private investment and means the final rise in output is smaller than the simple multiplier suggests.

  1. APrivate investment is unaffected because output rises by the full multiplier amount
  2. BHigher income raises money demand, pushing interest rates up and partially crowding out interest-sensitive private investmentCorrect
  3. CPrivate investment rises because interest rates fall with higher income
  4. DPrivate investment falls only if the government finances spending by printing money
  5. Crowding out occurs only when the economy is in a liquidity trap

Explanation

With a fixed money supply, higher income increases transactions demand for money and raises interest rates, which reduces interest-sensitive investment, so the multiplier effect is partly offset. Printing money would reduce crowding out, and in a liquidity trap crowding out is minimal rather than exclusive.

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