How Big is the Crowding-Out Effect of User Fees in the Rural Areas of Ethiopia - Essay Example

1. Introduction. The regulatory ities often employ fiscal policy, monetary policy or a combination of both to sway the economy back to a desired equilibrium position. The manner in which the government employs both policies may result to crowding-out or crowding-in. This paper is aimed at explaining crowding-out using either the IS-LM or the Philips’s curve and to show how it affects the economy as it is used as a tool for achieving economic objectives of monetary and fiscal authorities. To achieve this objective, the IS/LM model will be employed to see how various policy measures affect the interest rate, budget surplus and deficit (Visser, 2004). We begin by defining fiscal policy and monetary policy. The study later provides a description of the IS/LM model in section 3 and finally, an explanation of the crowding out effect using the IS/LM model. The last part of the paper will relate the crowding out effect to the real world particularly the UK as the Bank of England uses it as a fiscal policy tool. 2. Fiscal Policy, Monetary Policy 2.1. Fiscal Policy Fiscal policy refers to a situation whereby the government restores equilibrium in the economy by making changes to taxes or government expenditure on public goods and services (Smullen and Hand, 2005). When there is under-utilisation of capacity, the government can increase capacity utilisation by reducing taxes (that is through a reduction in tax rates or tax base) or by increasing spending on public goods and services as well as subsidising the production of certain goods and services (Smullen and Hand, 2005; Visser, 2004) Fiscal policy aimed at increasing money supply is referred to as easy fiscal policy (Smullen and Hand 2005). On the other hand, when there is over-utilisation of capacity, the government either increases taxes (through and increase in tax rates or tax bases) or reduces spending on public goods and services (Black 2002). It also reduces subsidies and transfer payments. This type of fiscal policy is referred to as tight fiscal policy (Black 2002). 2.2 Monetary Policy Monetary policy is referred to as a means by which the central bank tries to sway the economy to equilibrium by influencing the supply of money (Black 2002). This is achieved through four main approaches, which include: printing more money; direct controls over money held by the money sector; open market operations and influencing the interest rate. Both tight and easy monetary policies can also be identified. Like easy fiscal policy, easy monetary policy is one whereby the central bank embarks on a policy to increase the supply of money. On the other hand tight monetary policy is a policy whereby the central bank embarks on a policy to limit the circulation of money such as increasing interest rates. 2.3 Crowding-out This is economic theory which propounds that interest rates will increase due to rising government borrowing in the money market. (Black, 2002). The government can always set the rate, borrow and honor its debts. This theory holds that increased government borrowing to finance increased expenditures and budget deficits will ‘crowd-out’ individuals and companies from the lending market (Black, 2002). This usually happens because the demand for money or loanable funds rises and thus, pushing up the interest rate. This situation makes the cost of capital to increase, leading to low returns. 3. The IS/LM Model The IS/LM model is made up of two curves, the IS curve and the LM curve (Visser, 2004). The IS curve, which represents the equilibrium conditions of the real (investment-savings equilibrium) side of the economy (Visser, 2004). For an open economy, the IS curve can be represented by the following equation (Visser, 2004). (1) Where Y= national income, Z= private expenditure (consumption and investment), i = interest rate, T= taxes, G= government spending, Ex = exports (receipts on the current account of balance of payments), e= exchange rate, Im = imports (payments on the current account of balance of payments). The LM curve is influenced by balance of payments, because differences in imports and exports affect the money supply: Md = Ms Md = Md(Y,i) Ms = m.C Where Md = money demand, Ms = money supply, M = money multiplier, C = volume of base money. The central bank creates base money by granting domestic credit as well as through open market operations such as the purchase of foreign exchange. Following from Visser (Visser, 2004), the base money supply at any point in time should be equal to the base money supply one period behind plus the change in the domestic credit supply D during that period and the change in the foreign-exchange reserves V. This change is equal to the balance-of-payments balance X of the non-financial sector (Visser, 2004). C = C-1 + ∆D + ∆V ∆V = X The central bank uses open-market operations through the sales and purchase of domestic debt instruments such as bonds and other debt issues as the instrument of monetary policy. The volume of this purchase can be denoted by H = ∆D. Following from above C = C-1 + X+H Ms = m(C-1 +X+H) This gives us the equation for the LM curve as follows (Visser, 2004): Md (Y, i) = m(C-1+ X+ H) (2) Equating the real side of the economy (equation (1)) to the monetary side (equation (2)) leads to the IS/LM model. Figure 1. Fiscal Policy a). Easy fiscal policy b). Tight fiscal policy At equilibrium, the equation for the IS curve is equal to that for the LM curve, that is the real side of the economy is equal to the monetary side of the economy and it is at this point that the LM curve cuts the IS curve (Visser, 2004). It should be noted that the IS curve has a negative slope, while the LM curve has a positive slope. Figure 1 above represents the initial equilibrium position of the IS/LM model. The equilibrium national income is given by Y1; the equilibrium interest rate is i1. Lets assume that the government embarks on an easy fiscal policy and reduces taxes T, this will result in a shift in the IS curve to the right from IS to IS’, establishing a new equilibrium point between the IS’ curve and the LM curve at a higher level of national income Y2 and at a higher rate of interest i2. This is shown in the figure 1a above. Conversely if the government decides to embark on a tight fiscal policy by say increasing tax rates or the tax base so as to increase the overall tax liability, this will lead to a decrease in the national income from Y1 to Y2 and as well as a decrease in the interest rate from i1 to i2, resulting in a leftward shift in the IS curve from IS to IS’. This establishes a new equilibrium position to the left. This effect is shown in figure 1b above. Figure 2 Monetary Policy. a). Easy monetary policy b). Tight monetary policy In the IS/LM model above, the intersection of LM and IS represent the equilibrium state of the economy. At this point, the national income is given by Y1, and the interest rate by i1. In the first case lets assume that the central bank embarks on an easy monetary policy by purchasing debt securities in the open market. This will lead to an increase in the supply of money and thus the national income. The LM curve will shift to the right creating a new equilibrium position at a higher national income Y2 and a lower interest rate i2. This is represented in figure 2a above. On the other hand, if instead the central bank decides to embark on a tight monetary policy by raising interest rates from i1 to i2, it will result to a decrease in the national income from Y1 to Y2 and a shift in the LM curve from LM to LM’. This is represented in figure 2b above. The crowding-out theory was employed by many governments in Africa in the early 80s in order to expand and provide highly subsidized primary (including material and childcare health) services to their population, though it did not quite yield fruits due to the poor economic performance of African in the 1980s and 1990s. (Asfaw et al, (2004) The crowding out theory, has however met with strong criticism in recent times. According to the Private Capital Hypothesis, government investment as a result of borrowing and thus, pushing up interest rates will be a complement rather than a substitute to private investment. (Spector, 2005). This leads to the crowding-in theory which also holds that increased government spending through borrowing leads to an increased market for private products through the accelerator principle. (Spector, 2005). BIBLIOGRAPHY Asfaw, A., Braun, V. J., Klasen, S. (2004) How Big is the Crowding-Out Effect of User Fees in the Rural Areas of Ethiopia? Implications for Equity and Resources Mobilization. World Development Vol. 32, No. 12, pp. 2065–2081 Black J. (2002). Easy fiscal policy. A Dictionary of Economics. Oxford University Press, 2002. Oxford Reference Online. Fratianni M., Spinelli F. (2001). Fiscal Dominance and Money Growth in Italy: The Long Record. Explorations in Economic History, vol. 38, pp 252-272. Liviatan N. (2003). Fiscal Dominance and Monetary Dominance in the Israeli Monetary Experience. Bank of Israel Research Department Discussion Paper No. 2003.17 Sabaté M., Gadea M. D., Escario R. (2006) Does fiscal policy influence monetary policy? The case of Spain, 1874–1935. Explorations in Economic History, vol. 43, pp, 309–331 Smullen J., Hand N. (2005). Monetary Policy. A Dictionary of Finance and Banking. Oxford University Press. Oxford Reference Online. Spector L. C. ( 2005) Macroeconomic Models and the Determination Of Crowding-Out. Ball State University, Muncie, Indiana. Retrieved from website: http://web.bsu.edu/cob/econ/research/papers/bsuecwp200511spector.pdf Visser, H. (2004). A Guide to International Monetary Economics : Exchange Rate Theories, Systems and Policies 3rd Ed. Cheltenham, UK, Northhampton, MA Edward Elgar Publishing, Inc. Read More