The influence of monetary and fiscal policy On Aggregate Demand

Outline The influence of (expansionary) monetary policy on aggregate demand and on SR fluctuations The influence of (expansionary) fiscal policy on aggregate demand and on SR fluctuations Case of closed economy Case of open economy

Fiscal policy and monetary policy Fiscal policy: The use of the government’s tax and expenditure policies in an effort to influence the behavior of the economy (Ex: GDP and total employment). Monetary policy: The use of monetary variables such as the money supply , and rate of interest to influence the behavior of the economy.

How monetary policy influences aggregate demand How monetary policy influences aggregate demand? Case of a closed economy Recap: Aggregate demand curve is downward sloping due to : Wealth effect Interest rate effect RER effect In the closed economy, interest effect is important In the open economy, RER effect is important

How monetary policy influences aggregate demand How monetary policy influences aggregate demand? Case of a closed economy The most important reason for the down-ward sloping nature of aggregate demand is the interest rate effect. Theory of Liquidity Preference explains that the interest rate (real and nominal) adjusts to bring money supply and money demand into equilibrium. Real and nominal interest rates move together because the expected rate of inflation is constant in the SR.

Theory of Liquidity Preference: Money supply is fixed by the Central Bank and is independent of the rate of interest. Money is demanded for its liquidity (medium of exchange. Money demand is inversely related to interest rate at a given price level and output level . Interest rate represents the opportunity cost of holding money. Money is demanded for its capability to buy goods and services. The $ value of transactions (PY) is the other important determinant of money and causes shifts in money demanded at a given interest rate.

Equilibrium in the money market Interest rate adjusts to balance the supply and demand for money.

Theory of Liquidity Preference and Aggregate Demand Increase in prices and interest rate effect: A higher price level increases $ value of transactions and shifts aggregate demand to the right. This in turn raises the interest rate and reduces investment in the economy, which in turn reduces the quantity of goods and services demanded. Interest effect and AD curve (demand for goods and services) Increase in prices ---- Increase in demand for money--- increase in interest rate--- decrease in qty of goods and services demanded.

Impact of monetary policy on aggregate demand in the SR: Closed economy Recall: Shifts in aggregate demand occur with changes in consumption, Investment, and Govt expenditure, net exports at a given price level. In an open economy, NX=0 Changes in C, I, G, and NX can occur through fiscal policy or monetary policy. The Central Bank can change money supply through: Open market operations in the bond market and/ or in the foreign currency exchange market Changes in the Bank Rate

Impact of monetary policy on aggregate demand in the SR: Closed economy Expansionary monetary policy is implemented by the Central Bank by increasing the money supply. The expansionary monetary policy lowers the interest rate, and increases the quantity of goods and services demanded for a given price level. The contraction monetary policy (Central Bank contracts money supply) raises the interest rate and reduces the quantity of goods and services demanded for a given price level

How monetary policy influences aggregate demand? Case of open economy Recap: Interest rate = world interest rate for a small open economy with perfect capital mobility. The most important reasons for the down-ward sloping nature of aggregate demand are the interest rate effect and the real exchange rate. Increase in prices and RER effect: A higher price level increases RER and decreases net exports, which in turn reduces the quantity of goods and services demanded.

Expansionary monetary policy in an open- economy with flexible exchange rate Expansionary monetary policy by the Central Bank depreciates the RER causing net exports to rise. This increases the demand for goods and services and shifts the aggregate demand to the right. The effect of a monetary injection on aggregate demand is much stronger in an open economy as compared to a closed economy.

Expansionary monetary policy in an open- economy with fixed exchange rate Expansionary monetary policy by the Central Bank depreciates the RER causing net exports to rise. Central bank through open market operations in the foreign- currency exchange market can hold the value of the domestic currency constant. This reduces money supply in the economy. The Central Bank cannot simultaneously choose the size of the money supply and the value of the currency.

Expansionary fiscal policy and aggregate demand in the SR: Closed economy Recap: Shifts in aggregate demand at a given price level occur through changes in C, I, G, and NX. Fiscal policy influences C and I by altering spending decisions of households and firms. Changes in govt expenditure (G)alter aggregate demand directly. Increase in govt expenditure--- increases demand for goods and services- AD shifts to the right.

Govt expenditure and aggregate demand (AD) Size of govt expenditure and size of shift in AD depend on : Multiplier effect (k) Crowding-out effect on investment Crowding-out effect on NX K effect: additional shifts in the AD that result when expansionary fiscal policy increases income and thereby increases consumer expenditure Crowding-out effect on investment: offset in the AD that results when expansionary fiscal policy raises the interest rate and thereby reduces investment expenditure Crowding-out effect on NX: offset in the AD that results when expansionary fiscal policy in a small open economy with flexible exchange rate raises the RER and thereby reduces net exports

Multiplier effect Increase in income is spent on consumption and savings. K= 1/1-MPC in a closed economy MPC= Marginal propensity to consume In a closed economy, k is directly proportional to MPC K= 1/1-MPC+MPI in an open economy MPI= Marginal propensity to import In an open economy, k is indirectly proportional to MPI In general, the aggregate demand for goods and services rises by more than the govt expenditure due to the k effect Illustration: see example done in class

Crowding-out effect on investment Increase in govt expenditure causes rise in rate of interest and reduces residential and business investment expenditure thus choking off aggregate demand. If crowding out effect on investment is larger than the k effect, then AD for goods and services will rise by less than govt purchases.

Crowding-out effect on NX In a small open economy with perfect capital mobility, increase in govt expenditure causes a rise in the rate of interest thus raising domestic interest rate above the world interest rate. If the exchange rate is flexible, this causes an appreciation in the RER and reduces net exports and thereby the aggregate demand for goods and services.

Fiscal policy and effect on aggregate demand in a closed economy Expansionary fiscal policy is undertaken through an increase in govt expenditure on public works/ job creation programs. The size of shift in AD depends on the size of the k and the size of the crowding-out effect on investment. An increase in govt purchases increases the demand for goods and services by the value of the k thus raising the demand for money and interest rate. The rise in interest rate crowds out investment and AD shifts to the left at a given price level.

In a small open economy, expansionary fiscal policy causes Fiscal policy and effect on aggregate demand in an open economy: Flexible exchange rate In a small open economy, expansionary fiscal policy causes Crowding out effect on investment due to an increase in domestic interest rate (> than world interest rate) crowding out effect on NX due to an appreciation in the RER. Expansionary fiscal policy has no lasting effect on on the position of the aggregate demand curve

Fiscal policy and effect on aggregate demand in an open economy: Fixed exchange rate In a small open economy, expansionary fiscal policy causes domestic interest rate to rise above world interest rate. This appreciates the RER. The Central Bank through open market operations in the foreign currency exchange market (purchase of foreign currency) increases the supply of domestic currency and prevents changes in the exchange rate. Thus, the Bank prevents crowding out effect on NX. The supply of domestic currency by the Central bank causes domestic interest rate to fall and equal world interest rate. Thus, the Bank prevents crowding out effect on investment. The increase in money supply shifts the AD curve even farther to the right.

Fiscal policy and effect on aggregate demand in an open economy: Fixed exchange rate With a fixed exchange rate, an expansionary fiscal policy will have no crowding-out effects and will therefore cause a large increase in the demand for goods and services.

Coordination of Monetary and Fiscal policy For fiscal policy to have a lasting effect on the AD curve, the Central Bank must choose the appropriate exchange rate policy. Changes in taxes: reduction in taxes stimulates consumer expenditure through the multiplier effect crowds out net exports by increasing RER Deficit reduction Balanced budget limits the government’s options to increase AD. Deficit reduction will have no long lasting impact on AD in the event of a flexible exchange rate policy.

Stabilization Policy In theory, monetary policy and fiscal policy can be used to stabilize (offset) the effects of shocks to the Canadian economy. Identifying the shock and its affects and determining an appropriate response is often difficult. Monetary policy, although quickly implemented, affects the economy with considerable lags ( 1/2 to 1 1/2 years). Fiscal policy has a long implementation lag. Effects of policies are themselves uncertain.

Stabilization Policy: Current situation Active fiscal policy rarely used for aggregate demand management. Monetary policy’s primary focus is to maintain an inflation target while minimizing the effects of monetary policy on aggregate demand. Automatic stabilizers in place to minimize AD fluctuations. Taxes and transfers: when AD is low, taxes fall and transfers increase offsetting some of the low AD. Flexible exchange rate: an external AD shock (fall/rise in NX) is offset by exchange rate adjustment.