Title: The Influence of Monetary and Fiscal Policy on Aggregate Demand
1Chapter 20
- The Influence of Monetary and Fiscal Policy on
Aggregate Demand
2Ch 20 Part II
- Two Big Details
- Multiplier
- Crowding Out
- Discretionary Fiscal Policy
- Automatic Stabilizers
3Chapter 20 Outline
- Broad View
- Drop in AD (Great Depression)
- Monetary Fiscal Policy
- Economy Left to Itself
- Rise in AD (Overheating Economy 1968)
- Monetary Fiscal Policy
- Economy Left to Itself
- AS Shifts Left (Staglation)
- Monetary Fiscal Policy
- Economy Left to Itself
4Chapter 20 Outline
- Important Details
- Keynes Theory of Liquidity Preference
- How Interest Rate Determined in Short-Run
- How interest Rate affects Investment
- How Monetary Policy Works
- Crowding Out
- Policy Lags
- Recognition, Decision, Implementation,
Effectiveness -
5Time to bite the bullet Ready?
We can manage We got through last term!
Yes, we can do this!
Yeah!
6 Aggregate Demand
Price Level
AD C I G NX
PE
P2
Aggregate Demand
QE
Q2
Quantity of Output
7Aggregate Supply Long Run
Price Level
LRAS
P2
a
Pa
AD
Qa
Real GDP
8Aggregate Supply
Price Level
AS (2)
LRAS
P2
2
a
Pa
AD
Qa
Real GDP
Q2
9AD-AS ANALYSIS
Price Level
AS (2)
a
Pa
AD
Qa
Real GDP
10AD-AS ANALYSIS -Starting Point
Price Level
AS (2)
LRAS
a
Pa
AD
Qa
Real GDP
11CASE 1 A DROP IN AD
12AD-AS ANALYSIS AD FALL-Something Causes AD to
Drop
Price Level
AS (2)
a
Pa
b
Pb
AD
Qa
Real GDP
Qb
13AD-AS ANALYSIS AD FALL Fed increases money
supply
Price Level
AS (2)
Monetary Policy MS r I
a
Pa
b
Pb
AD
Qa
Real GDP
Qb
14AD-AS ANALYSIS AD FALL Congress Raises G or Cuts
T
Price Level
AS (2)
Fiscal Policy G T
C I
a
Pa
b
Pb
AD
Qa
Real GDP
Qb
15AD-AS ANALYSIS AD FALL Economy left to itself to
recover
Price Level
AS (2)
AS (0)
a
Pa
b
Pb
c
AD
Qa
Real GDP
Qb
16AD-AS ANALYSIS AD FALL Economy left to itself to
recover
Price Level
AS (2)
LRAS
AS (0)
a
Pa
b
Pb
c
AD
Qa
Real GDP
Qb
17CASE 2 A SURGE IN AD
18AD-AS ANALYSIS -Starting Point
Price Level
AS (2)
LRAS
a
Pa
AD
Qa
Real GDP
19AD-AS ANALYSIS Economy Begins to Overheat
Price Level
AS (2)
b
Pb
a
Pa
AD
Real GDP
Qb
Qa
20AD-AS ANALYSIS Fed tightens credit
Price Level
AS (2)
b
Pb
Monetary Policy MS r I
a
Pa
AD
Real GDP
Qb
Qa
21AD-AS ANALYSIS Congress cuts G or raises T
Price Level
AS (2)
b
Fiscal Policy G T
C I
Pb
a
Pa
AD
Real GDP
Qb
Qa
22AD-AS ANALYSIS Economy Adjusts By Itself
Price Level
AS (6)
AS (2)
c
Pc
b
Pb
a
Pa
AD
Real GDP
Qb
Qc
23CASE 3AS SHIFTS LEFT --- Stagflation
24AD-AS ANALYSIS -Starting Point
Price Level
AS (2)
LRAS
a
Pa
AD
Qa
Real GDP
25AD-AS ANALYSIS Stagflation Due to Oil Price Rise
Price Level
AS (2)
AS (6)
b
Pb
a
Pa
AD
Qa
Real GDP
Qb
26AD-AS ANALYSIS Fed Fights Unemployment
Price Level
AS (2)
AS (6)
Pc
c
b
Pb
Monetary Policy MS r I
a
Pa
AD
Qa
Real GDP
Qb
27AD-AS ANALYSIS Congress Fights Unemploy.
Price Level
AS (2)
AS (6)
Pc
c
Fiscal Policy G T
C I
b
Pb
a
Pa
AD
Qa
Real GDP
Qb
28AD-AS ANALYSISStagflation Economy Adjusts By
Itself
Price Level
AS (2)
AS (6)
b
Pb
a
Pa
AD
Qa
Real GDP
Qa
29Roar!
30Feds Policy Tools Raise MS
- Buy Government securities (0pen Market
Operations) - Lower Reserve Ratio
- Lower Discount Rate
- Note These Work in Reverse See Ch 15
31Theory of Liquidity Preference Keyness theory
The development of interest rates
- Summary
- An increase in the price level causes an increase
in the demand for money, which ... - ... leads to higher interest rates, thereby ...
- ... leads to reduced total spending (i.e. AD).
32Theory of Liquidity Preference Money Supply
- Fed fixes the Money Supply (MS)
- If Fed expands MS, shifts right
33The Money Market
Interest Rate
Money Supply
Quantity of Money
QFixed
34Theory of Liquidity Preference Supply and
Demand for Money
- Fed fixes the Money Supply (MS)
- If Fed expands MS, shifts right
35The Money Market
Interest Rate
Money Supply
Fed buys govt bonds, MS.
Quantity of Money
QFixed
36Theory of Liquidity Preference Money Demand
- People hold wealth in 2 financial assets
- Money Means of Exchange (convenient)
- Bonds Generate Interest
37Theory of Liquidity Preference Money Demand
- Interest rate (r ) price of money
- Higher interest rate raises opportunity cost of
holding money - Quantity Demanded of Money falls
38The Money Market
Interest Rate
Money Demand
r0
Quantity of Money
Q0
39The Money Market
Interest Rate
Money Demand
r1 r0
Quantity of Money
Q1
Q0
40Equilibrium in the Money Market
Interest Rate
Money Supply
Money Demand
Quantity of Money
QFixed
41Equilibrium in the Money Market
Interest Rate
Money Supply
rE
Money Demand
Quantity of Money
QFixed
42Equilibrium in the Money Market
Interest Rate
Money Supply
MS M D are equal .
rE
Money Demand
Quantity of Money
QFixed
43Investment Interest Rate
Interest Rate
Investment Demand
r0
Investment
Inv0
44Money Market Investment
45Equilibrium in the Money Market
Interest Rate
Money Supply
Money Demand Rises
rE
Money Demand
Quantity of Money
QFixed
46Changes in Money Supply
Interest Rate
MS0
rE0
Money Demand
Quantity of Money
QFixed0
47Changes in Money Supply
Interest Rate
MS0
MS1
rE0
Money Demand
Quantity of Money
QFixed0
48Changes in Money Supply
Interest Rate
MS0
MS1
rE0
Money Demand
Quantity of Money
QFixed0
49Changes in Money Supply
Interest Rate
MS0
MS1
rE0
rE1
Money Demand
Quantity of Money
QFixed0
QFixed1
50How Monetary Policy Works
51Interest-Rate Targets and Fed Policy
- Monetary policy can be described either in terms
of the money supply or in terms of the interest
rate. - Changes in monetary policy can be viewed either
in terms of a changing target for the interest
rate or in terms of a change in the money supply. - A target for the federal funds rate affects the
money market equilibrium, which influences the
aggregate demand.
52Quick Quiz!
- Use the theory of liquidity preference to explain
how a decrease in the money supply affects the
equilibrium interest rate. - How does this change in monetary policy affect
the aggregate demand curve?
53How Fiscal Policy Influences Aggregate Demand
- Fiscal policy refers to govts choices G T
- In the short-run, fiscal policy affects the
aggregate demand.
54How Fiscal Policy Works Government Purchases
- Step 1 Government purchases (G) rises
- Step 2 AD rises
55How Fiscal Policy Works Tax Cuts
- Step 1 Cut in Taxes
- Step 2 Increases Consumer Spending
- Step 3 AD rises
- Note This works in reverse
56Changes in Government Purchases
- Two macroeconomic effects from government
purchases (G) - Multiplier Effect
- Crowding-Out Effect
57Multiplier Effect of Government Purchases
- MULTIPLIER EFFECT Each 1 spent by govt raises
AD by more than 1 - A 100b rise in G causes AD to shift right by
more than 100b.
58The Multiplier Effect
Price Level
AD1
Quantity of Output
59The Multiplier Effect
Price Level
An increase in government purchases initially
increases AD
100b
AD2
AD1
Quantity of Output
60The Multiplier Effect
Price Level
The multiplier effect can amplify the shift in AD
400b
AD3
AD2
AD1
Quantity of Output
61Government Purchases Multiplier
- Multiplier formula
-
- Multiplier 1 (1 - MPC)
- MPC is Marginal Propensity to Consume
- How much do people consume of one extra
- .
62Computing Keynes Multiplier
- If MPC .75 , people spend 75 cents of each
additional dollar. - Multiplier 1 / (1 - .75) 4
- If MPC .90, people spend 90 cents of each
additional dollar. - Multiplier 1/ (1 - .9) 10
63Multiplier
- AD shift change in G x Multiplier
- AD shift 100 b x 4
- AD shift 400 b
- AD shift change in G x Multiplier
- AD shift 100 b x 10
- AD shift 1,000 b
64The Multiplier Effect
Price Level
An increase in government purchases initially
increases AD
100b
AD2
AD1
Quantity of Output
65The Multiplier Effect
Price Level
The multiplier effect can amplify the shift in AD
400b
AD3
AD2
AD1
Quantity of Output
66The Crowding-Out Effect
- When govt purchases (G) rises
- Govt must borrow
- Causes Interest Rate to Rise
- Investment Falls
- So Crowding Out G I
Almost Done!
67Changes in Taxes
- When the government cuts taxes, it
- Increases households take-home pay, which ...
- results in households saving some of the
additional income, but - households will spend some on consumer
goods, thus - shifting the aggregate-demand curve to the
right.
68Changes in Taxes
- The size of the shift in aggregate demand
resulting from a tax change is also affected by
the multiplier and crowding-out effects. - The size of the shift in the aggregate demand is
also determined by the households perceptions
about the permanency of the tax change.
69Using Policy to Stabilize the Economy
- Many policymakers believe it necessary to use
monetary and fiscal policy to achieve any level
of aggregate demand and GDP that they wish. - Active monetary and fiscal intervention is
necessary to tame an inherently unstable private
sector. - The use of policy instruments stabilize aggregate
demand and production and employment.
70Using Policy to Stabilize the Economy
- Use of G T to stabilize economy is called
discretionary fiscal policies. - Keynesians believe in active use of such policy.
71Using Policy to Stabilize the Economy
- Some economists argue that the government should
avoid using monetary and fiscal policy to try to
stabilize the economy. They suggest the economy
should be left to deal with the short-run
fluctuations on its own. - Discretionary Fiscal policy affects the economy
with substantial lags.
72Four Policy Lags
- Recognition Lag Policy Makers realize that
something has gone wrong - Decision Lag Policy Makers decide whether to
intervene - Implementation Lag Time it takes to put policy
into place - Effectiveness Lag Time it takes for policy to
have impact on economy
73Automatic Stabilizers
- Automatic Stabilizers features built into US
economy that soften swings in economic activity. - Examples
- Personal Income Tax
- Corporate Income Tax
- Unemployment Benefits
74Quick Quiz!
- Suppose firms become pessimistic about the
future. What happens to aggregate demand? - If the Fed wants to stabilize aggregate demand,
how should it alter the money supply? If it does
this, what happens to the interest rate?
75The Economy in the Long-Run and Short-Run
- When thinking about the long-run economy the
Loanable Funds Theory is used to best describe
the changes that occur. - When thinking about the short-run economy, the
Liquidity-Preference Theory is used to best
describe the changes that occur.
76The Economy in the Long Run and Short Run
- In the Long-Run
- Output is determined by the supplies of capital
and labor and the available production
technology. - The interest rate adjusts to balance the supply
and demand for loanable funds. - The price level adjusts to balance the supply and
demand for money.
77The Economy in the Long Run and Short Run
- In the Short-Run
- The price level is stuck at some level and is
relatively unresponsive to changing economic
conditions. - The interest rate adjusts to balance the supply
and demand for money. - The level of output responds to changes in the
aggregate demand for goods and services.
78Conclusion
- Government macroeconomic policy should proceed
carefully and with an understanding of the
consequences of its policies in the short- and
long-run. - Fiscal policies can have long-run effects on
saving, investment, the trade balance and growth.
- Monetary policy can ultimately determine the
level of prices and affect the inflation rate.
79Were outta here On to Ch 21!
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