Real sector, banks and policy issues: An exploration in a dynamic macroeconomic model

This paper formulates a dynamic macroeconomic model with banks and two uses of credit, viz. for fixed capital and for working capital. The model was simulated for the dynamic path of the endogenous variables. To see the role of policy in a bad state, government expenditure was increased financed by enhanced deficit and by raising income taxes. In the money financed case long-term interest rate rises and investment falls leading to lower levels of output. On the other hand the effect of increased money supply is negative on the short-term interest rate and the price level. In the tax-financed case exactly the opposite happens. These results are contrary to the conventional wisdom.