Chapter 32 Influence of Monetary & Fiscal Policy on Aggregate Demand

How Monetary Policy Influences Aggregate Demand Remember: AD slopes downward b/c of wealth effect, interest rate effect & exchange rate effect All 3 effects occur simultaneously, but interest rate effect is most important

Theory of Liquidity Preference Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance - we assume nominal & real interest rates move together

Money Supply Is controlled by Federal Reserve Because Fed controls it w/o regard to other econ. Variables; it’s represented with vertical supply curve

Money Demand Liquidity – how easy asset can be converted into medium of exchange ($ is most liquid) As interest rate rises, the quantity of money demanded falls – downward sloping demand Interest rate adjusts to bring money demand and money supply into balance

Downward Slope of AD Curve When PL increases, people demand more $, this shifts money demand curve to the right With fixed money supply, interest rate must rise

With higher interest rate, return on saving increase so consumers more likely to save and less likely to invest in new housing Therefore, Q of goods & services will fall; basically explaining interest rate effect

Changes in Money Supply Fed buys bonds in open market operations – will increase supply of money; shifts money supply to right, interest rate falls & AD shifts right

Interest Rate Targets Monetary policy can be described either in terms of the money supply or the interest rate Fed sometimes targets a specific federal funds rate (interest rate for banks) rather than a certain money supply

The Fed & The Stock Market Fed will try to stabilize economy by lowering interest rates when stock market is down and by raising interest rates when stock market is soaring

Fiscal Policy & Aggregate Demand By changing taxing & spending, it shifts AD directly How much a change in gov’t purchases increases AD is based on Multiplier effect & Crowding Out effect

Fiscal Policy Influences Aggregate Demand Primary effect of fiscal policy in the short run is on AD If Fed changes money supply, they influence spending decisions of firms and households and thereby INDIRECTLY affect AD If Govt. changes tax rates, they influence the spending decisions of firms and households and thereby INDIRECTLY affect AD If Govt. changes its own spending, it DIRECTLY affects AD

If the Govt. increases spending by $20 billion dollars, how far does AD shift? To what extent does GDP increase? The Multiplier Effect suggests that ……. The shift in AD could be larger than the change in Govt. spending (larger than $20 b)

GDP +$20 G buys $20 from Boeing Increase Consumer Spending/ Boeing increases employment/ income Increase Consumer Spending/ Electronics hires more Electronics Industry. Spending Consumer Increase GDP +$20

Spending Multiplier MPC Fraction of extra income that a household consumes rather than saves If MPC = .80…..it means that……. For every extra dollar of income the household earns, the household will spend 0.80…and save 0.20

If MPC is 0.80, then MPS is ….. 0.20 If Govt. spends $20b…then that is extra income for Boeing and they will spend……. $16 b and save $4b….. and that spending is an extra $16b income for others, of that they will spend….. $12.8 b and save $3.2 b……. And that spending is an extra $12.8b income for others, of that they will spend….. $10.24 b and save $2.56b…..and so on and on….

So the multiplier is 1 / (1-MPC) …. or …. 1/MPS ……so the original $20 b of increased govt. spending could generate a total of …… $100 b ……..how? $20 b initial increase x 1/.20 …. $20 b x 5 = $100 b COULD?????? Why the word “could” ?

MPC = .80 What if the govt. purchased $20 b from Boeing, but instead of expanding production and labor force, they simply put the $20 b in savings…….? The Multiplier is now 1 and the impact on the GDP is and increase of only $20 instead of $100….. What if they spent $10b of the $20….?

The larger the MPC, …the ….. Larger the Multiplier……..Explain

Logic of multiplier applies to any component of AD and GDP A small initial change in (C or I or G or Nx) Can result in a multiplied effect on AD and GDP

Change in Taxes When the Govt. increase or decrease tax…the multiplier is applied to the change in spending …but must figure out what the change in spending will be. If the govt. cuts tax by $10, it increases DI by $10…..but….. DI is not a part of AD (C,I,G,Nx) …..so….. a $10 tax cut will increase C by …… Tax x MPC …… logic…

If you now have $10 extra, you will not spend all of it, but rather you will spend a % of the additional income based on MPC….so….. Tax cut $10 = increase C by ($10 x MPC .80) = $8 and increase savings by $2 Now can apply multiplier to increase in amount of C , and NOT the size of the tax

If MPC = .80 Tax cut $10 = Increase DI $10= Increase C $8 Increase GDP $40

Crowding Out Effect

Crowding Out Effect If gov’t uses fiscal policy to expand (lowers taxes, increases spending) it will have multiplier effect on AD, but it also will cause interest rate to rise This rise in interest rate will decrease investment, which lowers AD thereby “crowding out” some of the growth (gov’t spending crowds out investment spending)

Crowding Out

G increase spending  AD shifts rt. money market  MD shifts right  IR rise  Inv. Decreases AD shifts left

G = AD shift right But also causes IR to rise and lowers Inv and AD As G increases spending, the resulting increase in IR “CROWDS OUT” Investment and prevents AD from expanding as much as intended. Can PREVENT expansionary fiscal policy from reaching its goal.

Consider “Crowding In” effect Nx effect