Copyright © 2004 South-Western 21 The Influence of Monetary and Fiscal Policy on Aggregate Demand

Copyright © 2004 South-Western What’s Important in Chapter 21 Monetary Policy Fiscal Policy Pro’s & Con’s of Stabilization Policy (See also Debate #1, Ch 23) Automatic Stabilizers

Copyright © 2004 South-Western Preliminary: Aggregate Demand Many factors influence aggregate demand besides monetary and fiscal policy. In particular, desired spending by households and business firms determines the overall demand for goods and services.

Copyright © 2004 South-Western Preliminary: Aggregate Demand and Government Intervention When desired spending changes, aggregate demand shifts, causing short-run fluctuations in output and employment. Monetary and fiscal policy are sometimes used to offset those shifts and stabilize the economy.

Copyright © 2004 South-Western HOW MONETARY POLICY INFLUENCES AGGREGATE DEMAND The aggregate demand curve slopes downward for three reasons: The wealth effect The interest-rate effect The exchange-rate effect

Copyright © 2004 South-Western HOW MONETARY POLICY INFLUENCES AGGREGATE DEMAND For the U.S. economy, the most important reason for the downward slope of the aggregate-demand curve is the interest-rate effect.

Copyright © 2004 South-Western The Theory of Liquidity Preference Keynes developed the theory of liquidity preference in order to explain what factors determine the economy’s interest rate. According to the theory, the interest rate adjusts to balance the supply and demand for money. This theory applies to the short run so we assume that nominal and real interest rates move in the same direction and by the same amount. That is, expected inflation doesn’t change.

Copyright © 2004 South-Western The Theory of Liquidity Preference Money Supply The money supply is controlled by the Fed through: Open-market operations Changing the reserve requirements Changing the discount rate Because it is fixed by the Fed, the quantity of money supplied does not depend on the interest rate. The fixed money supply is represented by a vertical supply curve.

Copyright © 2004 South-Western The Theory of Liquidity Preference Money Demand Money demand is determined by several factors. According to the theory of liquidity preference, one of the most important factors is the interest rate. People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services. The opportunity cost of holding money is the interest that could be earned on interest-earning assets. An increase in the interest rate raises the opportunity cost of holding money. As a result, the quantity of money demanded is reduced.

Figure 1 Equilibrium in the Money Market Quantity of Money Interest Rate 0 Money demand Quantity fixed by the Fed Money supply r2r2 M2M2 d M d r1r1 Equilibrium interest rate Copyright © 2004 South-Western

The Theory of Liquidity Preference Equilibrium in the Money Market According to the theory of liquidity preference: The interest rate adjusts to balance the supply and demand for money. There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded equals the quantity of money supplied.

Copyright © 2004 South-Western The Theory of Liquidity Preference Equilibrium in the Money Market If interest rate is above equilibrium, those holding excess money will deposit it in interest bearing accounts or bonds This increased demand drives interest rates down These lower rates encourage the public to hold money Until the money held equals the money supply

Copyright © 2004 South-Western The Theory of Liquidity Preference Equilibrium in the Money Market If interest rate is below equilibrium, those facing a shortage of money will sell bonds or withdraw funds from CDs or other interest bearing accounts This decreased demand for interest bearing accounts drives interest rates up These higher rates encourage the public to keep money in interest bearing accounts Until the money held equals the money supply

Copyright © 2004 South-Western Application of Liquidity Preference Theory to The Downward Slope of the Aggregate Demand Curve The price level is one determinant of the quantity of money demanded. A higher price level increases the quantity of money demanded for any given interest rate. Higher money demand leads to a higher interest rate. The quantity of goods and services demanded falls.

Copyright © 2004 South-Western Application of Liquidity Preference Theory to The Downward Slope of the Aggregate Demand Curve The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded.

Figure 2 The Money Market and the Slope of the Aggregate-Demand Curve Quantity of Money Quantity fixed by the Fed 0 Interest Rate Money demand at price levelP2P2,MD 2 Money demand at price levelP,MD Money supply (a) The Money Market(b) The Aggregate-Demand Curve which increases the equilibrium interest rate increases the demand for money... Quantity of Output 0 Price Level Aggregate demand P2P2 Y2Y2 Y P which in turn reduces the quantity of goods and services demanded. 1. An increase in the price level... r r2r2 Copyright © 2004 South-Western

Monetary Policy: SO WHAT? Changes in the Money Supply The Fed can shift the aggregate demand curve when it changes monetary policy. An increase in the money supply shifts the money supply curve to the right. Without a change in the money demand curve, the interest rate falls. Falling interest rates encourage businesses to invest in plant and equipment and you and I to buy more new houses. More investment increases the quantity of goods and services demanded.

Figure 3 A Monetary Injection MS 2 Money supply, MS Aggregate demand,AD Y Y P Money demand at price levelP AD 2 Quantity of Money 0 Interest Rate r r2r2 (a) The Money Market (b) The Aggregate-Demand Curve Quantity of Output 0 Price Level which increases the quantity of goods and services demanded at a given price level the equilibrium interest rate falls When the Fed increases the money supply... Copyright © 2004 South-Western

Monetary Policy: SO WHAT? Changes in the Money Supply When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the right. When the Fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the left.

Copyright © 2004 South-Western The Role of Interest-Rate Targets in Fed Monetary 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 aggregate demand.

Copyright © 2004 South-Western HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes. Fiscal policy influences saving, investment, and growth in the long run. In the short run, fiscal policy primarily affects the aggregate demand.

Copyright © 2004 South-Western Changes in Government Purchases When policymakers change the money supply or taxes, the effect on aggregate demand is indirect—through the spending decisions of firms or households. When the government alters its own purchases of goods or services, it shifts the aggregate- demand curve directly.

Copyright © 2004 South-Western The Multiplier Effect Government purchases are said to have a multiplier effect on aggregate demand. Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.

Copyright © 2004 South-Western Changes in Government Purchases There are two macroeconomic effects from the change in government purchases: The multiplier effect The crowding-out effect

Copyright © 2004 South-Western The Multiplier Effect The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Figure 4 The Multiplier Effect Quantity of Output Price Level 0 Aggregate demand,AD 1 $20 billion AD 2 AD 3 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion but the multiplier effect can amplify the shift in aggregate demand. Copyright © 2004 South-Western

A Formula for the Spending Multiplier The formula for the multiplier is: Multiplier = 1/(1 - MPC) An important number in this formula is the marginal propensity to consume (MPC). It is the fraction of extra income that a household consumes rather than saves. MPC=Change in Consumption/Change in Income For example, if you get a $1,000 raise and spend $750 of it, the MPC=750/1000=.75 or 75% or 3/4ths.

Copyright © 2004 South-Western A Formula for the Spending Multiplier If the MPC is 3/4, then the multiplier will be: Multiplier = 1/(1 - 3/4) = 4 In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

Copyright © 2004 South-Western Four Formulas to Compute Government Spending Need to Close Recessionary Gap MPC=Change in Consumption/Change in Income Multiplier=m=1/1-MPC Change in equilibrium RGDP=Change in Government Spending times multiplier=Change in G x “m” Change in G=Amount of Recessionary Gap/m

Copyright © 2004 South-Western Four Formulas to Compute Government Spending Need to Close Recessionary Gap MPC=80% Amount of Recessionary Gap=$500 billion How much of an increase in Government Spending do I need to eliminate the Recession?

Copyright © 2004 South-Western Four Formulas to Compute Government Spending Need to Close Recessionary Gap MPC=80% Amount of Recessionary Gap=$500 billion How much of an increase in Government Spending do I need to eliminate the Recession? ANSWER: m=1/(1-MPC)=1/(1-.8)=5 G=$500 billion/5=$100 billion

Copyright © 2004 South-Western The Crowding-Out Effect Fiscal policy may not affect the economy as strongly as predicted by the multiplier. An increase in government purchases causes the interest rate to rise. A higher interest rate reduces investment spending.

Copyright © 2004 South-Western The Crowding-Out Effect This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

Figure 5 The Crowding-Out Effect Quantity of Money Quantity fixed by the Fed 0 Interest Rate r Money demand,MD Money supply (a) The Money Market which increases the equilibrium interest rate the increase in spending increases money demand... MD2D2 Quantity of Output 0 Price Level Aggregate demand, AD 1 (b) The Shift in Aggregate Demand which in turn partly offsets the initial increase in aggregate demand. AD 2 AD 3 1. When an increase in government purchases increases aggregate demand... r2r2 $20 billion Copyright © 2004 South-Western

The Crowding-Out Effect When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger. Usually the multiplier effect is larger.

Copyright © 2004 South-Western Changes in Taxes When the government cuts personal income taxes, it increases households’ take-home pay. Households save some of this additional income. Households also spend some of it on consumer goods. Increased household spending shifts the aggregate- demand curve to the right.

Copyright © 2004 South-Western Changes in Taxes The size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding-out effects. It is also determined by the households’ perceptions about the permanency of the tax change.

Copyright © 2004 South-Western Pros and Cons of Stabilization Policy SHOULD WE USE POLICY TO STABILIZE THE ECONOMY Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946.

Copyright © 2004 South-Western The Case for Active Stabilization Policy The Employment Act has two implications: The government should avoid being the cause of economic fluctuations. The government should respond to changes in the private economy in order to stabilize aggregate demand.

Copyright © 2004 South-Western The Case against Active Stabilization Policy Some economists argue that monetary and fiscal policy destabilizes the economy. Monetary and fiscal policy affect the economy with a substantial lag. They suggest the economy should be left to deal with the short-run fluctuations on its own.

Copyright © 2004 South-Western Automatic Stabilizers Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Automatic stabilizers include the tax system and some forms of government spending.

Copyright © 2004 South-Western Review of Fiscal Policy Recession (recognize in graph form) Cut taxes (and continue government spending, likely leading to government deficit) Increase C and I causes Initial increase in aggregate demand Multiplier takes over limited by Crowding out effect due to government borrowing PL increases; RGDP increases; U rate decreases until we get to NRGDP

Copyright © 2004 South-Western Review of Fiscal Policy Recession (recognize in graph form) Increase Government Spending (G) but no increase in taxes, likely causing deficit Initial increase in aggregate demand Multiplier takes over limited by Crowding out effect as government borrows to pay deficit PL increases; RGDP increases; U rate decreases until we get to NRGDP

Copyright © 2004 South-Western Review of Monetary Policy Recession (recognize in graph form) Increase Money Supply Interest rates decrease Investment increase Initial increase in aggregate demand Multiplier takes over limited by PL increases; RGDP increases; U rate decreases until we get to NRGDP

Copyright © 2004 South-Western Review of Fiscal Policy Inflationary gap (recognize in graph form) Decrease Government spending without offsetting decrease in taxes, likely leading to surplus Initial decrease in aggregate demand Multiplier takes over in reverse PL decreases; RGDP decreases; U rate increases until we get to NRGDP

Copyright © 2004 South-Western Review of Fiscal Policy Inflationary gap (recognize in graph form) Increase taxes without increased spending, likely leading to government surplus Decreased C and I causes Initial decrease in aggregate demand Multiplier takes over in reverse PL decreases; RGDP decreases; U rate increases until we get to NRGDP

Copyright © 2004 South-Western Review of Monetary Policy Inflationary gap (recognize in graph form) Decrease Money Supply Increase interest rates Decrease Investment Initial decrease in aggregate demand Multiplier takes over in reverse PL decreases; RGDP decreases; U rate increases until we get to NRGDP

Copyright © 2004 South-Western Supply-Side Economics Permanent Tax Cuts mean owners and workers get to keep more money Lead to more effort by firms and workers Leads to an increase in SRAS AND an increase in LRAS AND more tax revenues (Laffer Curve)