Jennifer P. Wissink ©2019 Jennifer P. Wissink, all rights reserved. Adding Inflation To Our Model: Macro Aggregate Demand and Macro Aggregate Supply Lecture 19 Jennifer P. Wissink ©2019 Jennifer P. Wissink, all rights reserved. April 8, 2019 1 1

i>clicker question Suppose the fiscal guys decide to stimulate the economy by increasing $G. Suppose the monetary guys want to help out in any way they can to make the fiscal guys look good. So, they would... sit on their hands and do nothing. buy government securities from the public. sell government securities to the public. decrease taxes. increase the discount rate. In the news: Herman Cain and Stephen Moore are the beginning of Trump's 'politicization' of the Fed: Barclays https://www.cnbc.com/2019/04/06/trump-fed-picks-stephen-moore-herman-cain-will-politicize-central-bank.html

Issue: Fed Accommodation of Fiscal Policy (of an Expansionary Fiscal Policy, in this case) An expansionary fiscal policy (higher government spending or lower taxes) will increase aggregate output (income). In turn, higher income will shift the money demand curve to the right, and put upward pressure on the interest rate. If the money supply were unchanged following an increase in the demand for money, the interest rate would rise. But if The Fed were to “accommodate” the fiscal expansion, the interest rate would not rise. What would be true if The Fed accommodated a fiscal contraction? 3

An Increase in G with Accommodation by The Fed AEd G AEd Y MD r Id AEd Y 45° help Y r r Id M 4

Policy Review Expansionary… Contractionary… Monetary  Ms up r down Id up AEd up Y up MD up r up  Id down  AEd down Y down Final result: Y up, r down, Id up C up Fiscal  G up (or use taxes) AEd up Y up Final result: Y up, r up, Id down C up Contractionary… Monetary  Ms down r up Id down AEd down Y down MD down r down  Id up  AEd up Y up Final result: Y down, r up, Id down C down Fiscal  G down (or use taxes) AEd downY down MD down r down  Id up  AEd up Y up Final result: Y down, r down, Id up C down 5

The Macroeconomic Policy Mix FISCAL POLICY Expansionary ( G or T) Contractionary ( G or T) Expansionary ( Ms) Y↑, r?, I?, C↑ Y?, r↓, I↑, C? MONETARY POLICY Contractionary ( Ms) Y ?, r , I , C ? Y , r ?, I ?, C Key: : Variable increases. : Variable decreases. ?: Forces push the variable in different directions. Without additional information, we cannot specify which way the variable moves.

Example of How Sensitivity Impacts Efficacy AEd G AEd Y MD r Id AEd Y 45° help Y r r Id M 7

Putting it all Together. Suppose you are given the following: C = consumption G = govern. spending MD = money demand Id = investment desired T = taxes MS = money supply Y = aggregate output(income) r = interest rate rrr = required reserve ratio Yd= disposable income C = 600 + 0.75Yd Id = 2000 – 1500r G=100 T=100 EX=0 IM=0 Money demand: MD = 900 – 1000r; The required reserve ratio for all banks in this economy is rrr=10%. No bank holds excess reserves, and everybody keeps all their money in the banking system (so no currency). The total reserves in the banking system are TR=$70. With all that, answer the following: 1. What is the total money supply? 2. What is the equilibrium interest rate? 3. What is the equilibrium level of Y, i.e., Y*? NOW Suppose: YFE=$9,600 4. Should The Fed buy or sell securities to achieve this goal? 5. How much (give a dollar figure) should The Fed buy or sell? 8

C = 600 + 0.75Yd Id = 2000 – 1500r G=100 T=100 EX=0 IM=0 Money demand: MD = 900 – 1000r and rrr=10% and TR=$70 9

C = 600 + 0.75Yd Id = 2000 – 1500r G=100 T=100 EX=0 IM=0 Money demand: MD = 900 – 1000r and rrr=10% and TR=$70 10

r r I M AEd 45° help Y

Try MORE! Same set up, but now assume YFE=$9,000 Add an import function... and do the problem over. Make the tax function more interesting...and do the problem over. How about FISCAL policy instead of monetary... and do the problem over. 12

END OF MATERIAL FOR PRELIM 2 Thank goodness!

Newest Wrinkle – The Price Level Up to now we’ve pretty much (not completely) ignored the overall price level - now we want to re-introduce it. How will it alter our understanding of the model and fiscal and monetary policy? Where does the price level appear in the model? In the Money Demand Function! Recall, MD depends on r, Y and PL where PL is the aggregate price level HOW? It’s time to introduce two new notions: (Macro) Aggregate Demand = AD (Macro) Aggregate Supply = AS, both SR-AS and LR-AS 14

The Macro Aggregate Demand Curve - (M)AD The Aggregate Demand (AD) curve is a curve that shows the relationship between aggregate output/income (Y) and the price level (PL) when the money market and goods market are both in equilibrium. The Aggregate Demand (AD) curve is negatively sloped. To derive the Aggregate Demand Curve, we examine what happens to aggregate output/income (Y) when the price level (PL) changes, assuming no changes in government spending (G), net taxes (T), or the monetary policy variable (Ms). And no changes in exports and imports, which we are ignoring for now anyway. 15

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