Principles of Macroeconomics PowerPoint Presentations for Principles of Macroeconomics Sixth Canadian Edition by Mankiw/Kneebone/McKenzie Adapted for the Sixth Canadian Edition by Marc Prud’homme University of Ottawa

the influence of monetary and fiscal policy on aggregate demand Chapter 15 Copyright © 2014 by Nelson Education Ltd.

the influence of monetary and fiscal policy on aggregate demand In this chapter we examine in more detail how the government’s tools of monetary and fiscal policy influence the position of the aggregate- demand curve. We will also see how the tools of monetary and fiscal policy can shift the aggregate-demand curve and, in doing so, affect short-run economic fluctuations. Copyright © 2014 by Nelson Education Ltd.

how monetary policy influences AGGREGATE DEMAND The aggregate-demand curve slopes downward for three reasons: The Wealth Effect The Interest Rate Effect The Real Exchange Rate Effect The Interest Rate Effect is the most important reason for the downward slope of the aggregate-demand curve. Copyright © 2014 by Nelson Education Ltd.

The Theory of Liquidity Preference The theory of liquidity preference: Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance. In the analysis that follows, the expected rate of inflation is held constant. Copyright © 2014 by Nelson Education Ltd.

The Theory of Liquidity Preference: Money Supply The Bank of Canada alters the money supply using two methods: Changing the bank rate Open-market operations Buying and selling federal government bonds Foreign-exchange market operations Copyright © 2014 by Nelson Education Ltd.

FIGURE 15.1: The Supply of Money Copyright © 2014 by Nelson Education Ltd.

The Theory of Liquidity Preference: Money Demand Although many factors determine the quantity of money demanded, the one emphasized by the theory of liquidity preference is the interest rate. The other key determinant of the quantity of money demanded is the fact that money is used to buy goods and services. Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd.

FIGURE 15.2: The Demand for Money Copyright © 2014 by Nelson Education Ltd.

FIGURE 15.3: Shifts in the Demand for Money Copyright © 2014 by Nelson Education Ltd.

FIGURE 15.4: Equilibrium in the Money Market Copyright © 2014 by Nelson Education Ltd.

The Downward Slope of the Aggregate-Demand Curve What are the implications of the theory of liquidity preference for the aggregate demand for goods and services? Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. FIGURE 15.5: The Money Market and the Slope of the Aggregate-Demand Curve Copyright © 2014 by Nelson Education Ltd.

Changes in the Money Supply One important variable that shifts the aggregate- demand curve is monetary policy. To see how monetary policy affects the economy in the short run, suppose that the Bank of Canada causes the money supply to increase. Copyright © 2014 by Nelson Education Ltd.

FIGURE 15.6: A Monetary Injection in a Closed Economy Copyright © 2014 by Nelson Education Ltd.

Open-Economy Considerations How does a monetary injection affect the aggregate-demand curve in a small open economy? Dirk Ercken /Shutterstock Copyright © 2014 by Nelson Education Ltd.

FIGURE 15.7: A Monetary Injection in an Open Economy Copyright © 2014 by Nelson Education Ltd.

Open-Economy Considerations: Flexible Exchange Rate Flexible exchange rate: a policy by which the value of the exchange rate is allowed to vary without interference by the central bank StockThings/Shutterstock Copyright © 2014 by Nelson Education Ltd.

Open-Economy Considerations: Flexible Exchange Rate In a small open economy with a flexible exchange rate, a monetary injection by the Bank of Canada causes the dollar to depreciate in value. This causes an increase in the demand for Canadian- produced goods and services that is not realized in a closed economy. In the end, a monetary injection in an open economy shifts the aggregate-demand curve farther to the right than it does in a closed economy. Copyright © 2014 by Nelson Education Ltd.

Open-Economy Considerations: Fixed Exchange Rate Fixed exchange rate: a policy by which the value of the exchange rate is held fixed by the central bank The Bank of Canada cannot simultaneously choose the size of the money supply and the value of the Canadian dollar. Copyright © 2014 by Nelson Education Ltd.

TABLE 15.1: A Monetary Injection in an Open Economy Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Explain how a decrease in the money supply affects the money market and the position of the aggregate-demand curve. What is the effect for a closed economy and for a small open economy? Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. The Multiplier Effect Multiplier effect: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending Copyright © 2014 by Nelson Education Ltd.

FIGURE 15.8: The Multiplier Effect Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Multiplier Effect This multiplier effect arising from the response of consumer spending can be strengthened by the response of investment to higher levels of demand. This positive feedback from demand to investment is sometimes called the investment accelerator. Copyright © 2014 by Nelson Education Ltd.

A Formula for the Spending Multiplier An important number in this formula is the marginal propensity to consume (MPC): the fraction of extra income that a household consumes rather than saves. Copyright © 2014 by Nelson Education Ltd.

A Formula for the Spending Multiplier Change in GVT purchases = $5 billion First change in Consumption = MPC X Second change in Consumption = MPC2 X Third change in Consumption = MPC3 X . Total change in demand = (1 + MPC + MPC2 + MPC3 + …) x 5 billion Copyright © 2014 by Nelson Education Ltd.

A Formula for the Spending Multiplier Multiplier = 1 + MPC + MPC2 + MPC3 + … Multiplier = 1 / (1 – MPC) In an open economy: Multiplier = 1 / (1 – MPC + MPI) Copyright © 2014 by Nelson Education Ltd.

Other Applications of the Multiplier Effect The multiplier effect applies to any event that alters spending on any component of GDP: Consumption Investment Government purchases Net exports Copyright © 2014 by Nelson Education Ltd.

The Crowding-Out Effect on Investment Crowding-out effect on investment: the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending Copyright © 2014 by Nelson Education Ltd.

FIGURE 15.9: The Crowding-Out Effect on Investment Copyright © 2014 by Nelson Education Ltd.

Open-Economy Considerations So far the effects of fiscal policy on aggregate demand have ignored open-economy considerations. Copyright © 2014 by Nelson Education Ltd.

Open-Economy Considerations: Flexible Exchange Rate In a small open economy, an expansionary fiscal policy causes the dollar to appreciate. Because this appreciation of the dollar causes net exports to fall, there is an additional crowding-out effect that reduces the demand for Canadian-produced goods and services. In the end, fiscal policy has no lasting effect on aggregate demand. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. FIGURE 15.10: A Fiscal Expansion in an Open Economy with a Flexible Exchange Rate Copyright © 2014 by Nelson Education Ltd.

Open-Economy Considerations Crowding-out effect on net exports: the offset in aggregate demand that results when expansionary fiscal policy in a small open economy with a flexible exchange rate raises the real exchange rate and thereby reduces net exports Copyright © 2014 by Nelson Education Ltd.

Open-Economy Considerations: Fixed Exchange Rate If the Bank of Canada chooses to prevent any change in the exchange rate, expansionary fiscal policy will have no crowding-out effects and will therefore cause a very large increase in the demand for goods and services. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. FIGURE 15.11: A Fiscal Expansion in an Open Economy with a Fixed Exchange Rate Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Open-Economy Considerations: The Coordination of Monetary and Fiscal Policy For fiscal policy to have a lasting effect on the position of the aggregate-demand curve, the Bank of Canada must choose the appropriate exchange rate policy. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Changes in Taxes The other important instrument of fiscal policy, besides the level of government purchases, is the level of taxation. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Deficit Reduction During the 1990s and 2000s, Canadian governments at both the federal and the provincial levels took steps to reduce or eliminate their budget deficits. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Explain how a decrease in government expenditures affects the money market and the position of the aggregate-demand curve. What is the effect for (a) a closed economy and (b) an open economy when the Bank of Canada allows the exchange rate to vary, and for (c) an open economy when the Bank of Canada chooses to maintain a fixed value for the exchange rate? Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Active Learning Exercise The economy is in recession. Shifting the AD curve rightward by $20b would end the recession. A. If MPC = 0.8 and there is no crowding out, how much should the government increase G to end the recession? B. If there is crowding out, will the government need to increase G more or less than this amount? Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Active Learning Answers The economy is in recession. Shifting the AD curve rightward by $20b would end the recession. A. If MPC = 0.8 and there is no crowding out, how much should the government increase G to end the recession? Multiplier = 1 / (1 – 0.8) = 5 Increase G by $4b to shift aggregate demand by 5 x $4b = $20b. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Active Learning Answers The economy is in recession. Shifting the AD curve rightward by $20b would end the recession. B. If there is crowding out, will the government need to increase G more or less than this amount? Crowding out reduces the impact of G on AD. To offset this, the government should increase G by a larger amount. Copyright © 2014 by Nelson Education Ltd.

USING POLICY TO STABILIZE THE ECONOMY The case for active stabilization policy: Keynes claimed that the government should actively stimulate aggregate demand when aggregate demand appeared insufficient to maintain production at its full-employment level. The case against active stabilization policy: The primary argument against active monetary and fiscal policy is that these policies affect the economy with a long lag. Copyright © 2014 by Nelson Education Ltd.

Automatic Stabilizers Automatic stabilizers: changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession, without policy makers having to take any deliberate action Copyright © 2014 by Nelson Education Ltd.

A Flexible Exchange Rate as an Automatic Stabilizer In an open economy, policy makers can choose to make use of another type of automatic stabilizer: a flexible exchange rate. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. How does a reduction in government spending affect the aggregate-demand curve? How does your answer differ if we consider a closed economy versus an open economy? Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Classroom Activity Politics and Policy Find a current political proposal that would have economic implications. This can be a campaign promise by a candidate or a policy proposal by an office-holder. Name the politician and briefly describe the proposal. Consider the economic implications of this proposal. Is it more likely to affect aggregate demand or aggregate supply? Explain how this proposal would change the aggregate-demand curve—through consumption, investment, government spending, or net exports—or the aggregate-supply curve—through labour, capital, natural resources, or technology. Copyright © 2014 by Nelson Education Ltd.

Classroom Activity Politics and Policy (continued) Graph the impact of this proposal using aggregate demand and aggregate supply. Explain what happens to the price level and the level of output. Does this policy seem to be appropriate given the current economic conditions? Explain. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. The end Chapter 15 Copyright © 2014 by Nelson Education Ltd.