The Influence of Monetary and Fiscal Policy on Aggregate Demand

1
Chapter 20

• The Influence of Monetary and Fiscal Policy on
  Aggregate Demand

2
Chapter Outline

• What shifts AD Curve What shifts AS
• MONETARY POLICY in Action
• FISCAL POLICY in Action
• The Multiplier and Crowding Out
• Policy Lags

3
What shifts Aggregate Demand (AD) Curve

• Increases AD (shifts righht)
• Consumers Business More Confident
• Government Increases Purchases
• Taxes Are Cut
• Investment Rises Because of Fed
• Foreigners Buy More US Exports
• Note All these operate in reverse

4
The Aggregate Demand and Aggregate Supply Model
Price Level
AS (0)
PE
AD
QE
Quantity of Output
5
The Aggregate Demand and Aggregate Supply Model
Price Level
AS (0)
PE
AD
AD
QE
Quantity of Output
6
What shifts Aggregate Supply(AS) Curve

• Increases AS (shifts right)
• Lower Resource Prices
• Lower Inflationary Expectations
• Increased Productivity
• Supply Side Tax Cuts
• Note All these operate in reverse

7
The Aggregate Demand and Aggregate Supply Model
Price Level
AS (0)
PE
AD
QE
Quantity of Output
8
Recession When Business Consumers Lose
Confidence 2001
Price Level
AS (0)
PE
AD
QN
Quantity of Output
9
Recession When Business Consumers Lose
Confidence 2000
Price Level
AS (0)
PE
PE
AD
QE
QN
Quantity of Output
10
Feds Tools to Increase Money Supply

• Fed buys Government securities (0pen Market
  Operations)
• Fed Lowers Reserve Ratio
• Fed Lowers Discount Rate
• Note These Work in Reverse

11
How Monetary Policy Work

• Step 1 Money Supply Rises
• Step 2 Interest Rate Falls
• Step 3 Investment Rises
• Step 4 AD Rises

12
Theory of Liquidity Preference The Supply and
Demand for Money

• Money Supply is fixed by Fed it does not depend
  on the interest rate.
• Money Supply (MS) appears as a vertical supply
  curve.

13
The Money Market
Interest Rate
Money Supply
Quantity of Money
QFixed
14
Theory of Liquidity Preference The Supply and
Demand for Money

• Using Open-Market Operations, Fed can shift the
  MS curve left or right.
• Fed buys gov bonds
• Bank reserves rise MS rises.
• If Fed sells govt bonds
• Bank reserves decrease MS declines.

15
The Money Market
Interest Rate
Money Supply
If the Fed buys government bonds, money supply
increases.
Quantity of Money
QFixed
16
Keynes Theory of Liquidity Preference

• People Hold Wealth in 2 Financial Assets
• Money Convenient as means of exchange, but pays
  no interest
• Bonds Not easy to spend, but pay interest

17
Theory of Liquidity Preference The Supply and
Demand for Money

• Money Demand (MD)
• The lower the interest rate, the greater the
  quantity of money demanded
• MD curve shifts right if
• Income Rises
• Price Level Rises

18
Theory of Liquidity Preference The Supply and
Demand for Money

• A Lower Interest Rate lowers opportunity cost of
  holding money
• A Higher Interest Rate raises the cost of holding
  money and thus reduces the quantity of money
  people hold.

I can believe that
19
Money Demand Curve
Interest Rate
Money Demand
Quantity of Money
QFixed
20
The Money Market
Interest Rate
Money Demand
I0
Quantity of Money
Q0
21
The Money Market
Interest Rate
Money Demand
I1
I0
Quantity of Money
Q0
22
The Money Market
Interest Rate
Money Demand
I1
I0
Quantity of Money
Q1
Q0
23
Equilibrium in the Money Market

• Theory of Liquidity Preference
• Interest rate adjusts so MD MS
• At equilibrium interest rate, quantity of money
  demanded exactly equals the quantity of money
  supplied.

24
Equilibrium in the Money Market
Interest Rate
Money Supply
Money Demand
Quantity of Money
QFixed
25
Equilibrium in the Money Market
Interest Rate
Money Supply
IE
Money Demand
Quantity of Money
QFixed
26
Equilibrium in the Money Market
Interest Rate
Money Supply
Money Supply and Money Demand are equal at the
equilibrium interest rate.
IE
Money Demand
Quantity of Money
QFixed
27
Fed Increases Money Supply

• FED BUYS GOVT SECURITIES

28
Changes in Money Supply
Interest Rate
MS0
IE0
Money Demand
Quantity of Money
QFixed0
29
Changes in Money Supply
Interest Rate
MS0
MS1
IE0
Money Demand
Quantity of Money
QFixed0
30
Changes in Money Supply
Interest Rate
MS0
MS1
IE0
Money Demand
Quantity of Money
QFixed0
31
Changes in Money Supply
Interest Rate
MS0
MS1
IE0
IE1
Money Demand
Quantity of Money
QFixed0
QFixed1
32
Investment Schedule
Interest Rate
IE0
Investment
Investment
Inv0
33
Investment Schedule
Interest Rate

• Lower Interest Rate
• raises Investment

IE0
IE1
Investment
Investment
Inv0
Inv1
34
How Fiscal Policy Works Government Purchases

• Step 1 Government purchases rise
• Step 2 AD rises

35
How Fiscal Policy Works Tax Cuts

• Step 1 Cut in Taxes
• Step 2 Increases Consumer Spending
• Step 3 AD rises
• Note This works in reverse

36
How Fiscal Policy Can Stimulate An Economy in
Recession
Price Level
AS
PE
AD
QE
QN
Quantity of Output
37
How Fiscal Policy Can Stimulate An Economy in
Recession
Price Level
AS

• Fiscal Policy in Action

PE

• Congress Raises G or Cuts T

AD
QE
QN
Quantity of Output
38
How Fiscal Policy Works Government Purchases

• Government purchases rise
• AD rises

39
Changes in Government Purchases

• Two macro effects from govt purchases
• Multiplier Effect
• Crowding-Out Effect

• Not Bad
• so far

40
Multiplier Effect

• Each spent by govt raises AD by more than a
  dollar--- multiplier effect.
• Total impact on AD larger than
• initial rise in govt spending (G).

41
The Multiplier Effect
Price Level
AD1
Quantity of Output
42
Multiplier Effect
Price Level
Rise in G increases AD
AD2
AD1
Quantity of Output
43
Multiplier Effect
Price Level
Amplifies shift in AD
AD3
AD2
AD1
Quantity of Output
44
Multiplier Effect

• Multiplier formula
• Multiplier 1 (1 - MPC)
• MPC is the Marginal Propensity to Consume.

45
Computing Keynes Multiplier

• If MPC .80 , we spend 80 cents of each extra .
  
• Multiplier 1 / (1 - .8) 5
• If MPC .90, we spend 90 cents of each extra .
• Multiplier 1/ (1 - .9) 10

46
Computing Keynes Multiplier

• If MPC .80 , Multiplier 5
• Rise in Govt spending (G) of 100b
• Makes AD rise by 500b
• If MPC .90, Multiplier 10
• Rise in Govt spending (G) of 100b
• Makes AD rise by 1000b

47
Computing Keynes Multiplier

• If MPC .80 , Multiplier 5
• So Increase in Govt spending (G) of 100b
• Causes AD to rise by 500b

48
Multiplier Effect

• Multiplier formula
• Multiplier 1 (1 - MPC)
• MPC is the Marginal Propensity to Consume.
• Multiplier 1 / ( 1 - .8)
• 1/.2
• 5

49
The Multiplier Effect
Price Level 100
An increase in government purchases initially
increases AD
100b
AD2
AD1
Quantity of Output
50
The Multiplier Effect
Price Level 100
The multiplier effect can amplify the shift in AD
100b
AD3
AD2
AD1
Quantity of Output
51
The Multiplier Effect
Price Level 100
The multiplier effect can amplify the shift in AD
500b
AD3
AD2
AD1
Quantity of Output
52
Crowding-Out Effect

• An increase in govt purchases (G) inceases AD,
  but also raises interest rate
• This causes investment part of AD to fall
• So increase in AD from greater govt spending is
  small because of crowding out

53
The Crowding Out Effect
Price Level 100
increase in G increases AD
AD2
AD1
Quantity of Output
54
The Crowding Out Effect
Price Level 100
Rise in G increases AD but crowding out reduces
investment
AD2
AD1
Quantity of Output
55
The Crowding Out Effect
Price Level 100
Rise in G increases AD but crowding out reduces
investment
AD2
AD1
Quantity of Output
56
Using Policy to Stabilize the Economy

• Monetarists argue AGAINST stabilizing economy.
• Should cure itself of short-run fluctuations.
• Monetary and Fiscal policy affects the economy
  with substantial lags.

57
Four Policy Lags

• Recognition Lag See trouble
• Decision Lag Decide (not) to intervene
• Implementation Lag Put policy in place
• Effectiveness Lag Impacts economy

58
Automatic Stabilizers

• Automatic Stabilizers --- fiscal policy that
  automatically increase AD during recession
• Automatic stabilizes
• Personal Income Tax
• Corporate Profits Tax
• Unemployment Benefits
• Welfare Payments

• Oh!

59

• Return to the 1960s

60
DURING THE LATE 1960S

• 1965 At full employment
• LBJ launched Great Society
• Vietnam War escalated

61
Short-Run Impact from Changing AD
Price Level
AS (0)
LRAS
PE
AD
QN
Quantity of Output
62
Short-Run Impact from Raising AD
Price Level
AS (0)
LRAS
PE
AD
QN
Quantity of Output
Q 2
63
Economy Adjusts on Its Own to Rise in AD
AS (2)
Price Level
AS (0)
LRAS
P 2
PE
AD
QN
Quantity of Output
Q 2
64
The Economy in the Long Run and Short Run

• In the Short-Run
• Changes in Fiscal or Monetary Policy Can affect
  output level

65
The Economy in the Long Run and Short Run

• In the Long-Run
• Output determined by resources technology.
• Changes in Monetary Fiscal Policy Only affect
  the Price Level

66
Long-Run Impact from Changing AD
Price Level
P 2
PE
AD
QN
Quantity of Output
67
Using Policy to Stabilize the Economy

• Use of (T) and (G) to stabilize economy called
  discretionary fiscal policies.
• Those that accept this approach are called
  Keynesians.

68
Fiscal Policy Cools Off Economy
Price Level
AS (0)
PE
AD
QN
Quantity of Output
Q 2
69
Fiscal Policy Cools Off Economy
Price Level
AS (0)
PE
AD
QN
Quantity of Output
Q 2
70
Short-Run Impact from Changing AD
Price Level
AS (0)
PE
AD
QN
Quantity of Output
Q 2
71
Conclusion

• Macro policy should proceed carefully
• Fiscal policies have LR effects on saving,
  investment and growth.
• Monetary policy ultimately determines price level
  inflation rate.

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• End 20!