Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Eleven Monetary Policy and Fiscal Policy in the Short Run Macroeconomics by Curtis, Irvine and Begg Canadian Edition, McGraw-Hill Ryerson, 2007

©2007 McGraw-Hill Ryerson Ltd.Chapter 112 Learning Outcomes This chapter explains: The relationship between prices, aggregate expenditure, and aggregate demand The determinants of the slope and the position of the AD curve Short-run equilibrium output and price The objective of fiscal policy The effects of fiscal policy on output, prices, and the public debt The effects of monetary policy on output and prices in the short run How monetary and fiscal policy interact Recent monetary policy, fiscal policy, and economic conditions in Canada

©2007 McGraw-Hill Ryerson Ltd.Chapter The Effect of Changes in the General Price Level on Interest Rates Interest Rate i M 0 /P L(Y 0 ) i0i0 i1i1 Real Money Balances E i2i2 M 0 /P 1 M 0 /P 2 M 0 /P 1 M 0 /P 2 ΔP>0ΔP<0 Money Market Equilibrium M 0 /P = L(Y,i) A rise in P reduces the real money supply A fall in P increases the real money supply

©2007 McGraw-Hill Ryerson Ltd.Chapter Changes in Interest Rates under Different Demand Conditions Interest Rate i M 0 /P L(Y 0 ) i0i0 i2i2 Real Money Balances E i1i1 M 0 /P 1 M 0 /P 2 L 0 is more Elastic than L 1 L(Y 1 ) Less elastic of the money demand, the higher increase in interest rate given the same change of money supply.

©2007 McGraw-Hill Ryerson Ltd.Chapter Price, Aggregate Expenditure, and Aggregate Demand The linkages between change in the price level and changes in output can be summarized as follows:

©2007 McGraw-Hill Ryerson Ltd.Chapter Deriving the AD Curve based on a Fixed Nominal Money Supply Nominal Interest Rate i M 0 /P 0 L(Y 0 ) i1i1 Real Money Balances M 0 /P 1 (a) Money Market i2i2 ΔiΔi The interest sensitivity of the demand for money as shown by the slope of demand curve for money balances.

©2007 McGraw-Hill Ryerson Ltd.Chapter Deriving the AD Curve based on a Fixed Nominal Money Supply (b) Interest Rates and Expenditure Real Interest Rates A(r 0 )A(r 1 ) r0r0 r1r1 A(r) The interest sensitivity of planned expenditure as shown by the slope of A(r).

©2007 McGraw-Hill Ryerson Ltd.Chapter Deriving the AD Curve based on a Fixed Nominal Money Supply Expenditure Y1Y1 AE(r 1 ) A 0 (r 1 ) Real GDP Y0Y0 (c) Equilibrium Expenditure and Output AE(r 2 ) A 0 (r 0 ) The size of the expenditure multiplier, which is determined by the slope of AE.

©2007 McGraw-Hill Ryerson Ltd.Chapter Deriving the AD Curve based on a Fixed Nominal Money Supply P Y1Y1 AD 0 P0P0 Real GDP Y0Y0 (d) Aggregate Demand Y2Y2 P1P1 P2P2 Changes in P cause movements along AD

©2007 McGraw-Hill Ryerson Ltd.Chapter Short-Run Equilibrium Output and Price P AD 0 P0P0 Real GDP Y0Y0 AS 0 Price Level

©2007 McGraw-Hill Ryerson Ltd.Chapter Short-Run Equilibrium Output and Price P AD 0 P0P0 Real GDP Y0Y0 AS 0 Price Level (a) AD Shocks AD 1 AD 2 Y1Y1 Y2Y2 Demand shocks shift AD right and left, short-run equilibrium output and the price level move up and down together P1P1 P2P2

©2007 McGraw-Hill Ryerson Ltd.Chapter Short-Run Equilibrium Output and Price P AD 0 P0P0 Real GDP Y0Y0 AS 0 Price Level (b) AS Shocks AS 1 AS 2 Y2Y2 Y1Y1 Supply shocks shift AS up and down, short-run equilibrium output and the price level move in the opposite directions. P1P1 P2P2

©2007 McGraw-Hill Ryerson Ltd.Chapter Short-Run Equilibrium Output versus Potential Output P AD 0 P0P0 Real GDP YpYp AS 0 Price Level AD 1 AD 2 Y1Y1 Y2Y2 P1P1 P2P2 Potential GDP Inflationary GapRecessionary Gap

©2007 McGraw-Hill Ryerson Ltd.Chapter The Effect of Fiscal Policy on AD Fiscal policy objectives –Stable aggregate demand consistent with full employment and potential output –Control the debt ratio Fiscal policy instrument –Government’s budget balance Fiscal policy objectives are interdependent

©2007 McGraw-Hill Ryerson Ltd.Chapter Fiscal Policy and Aggregate Demand P AD 0 P0P0 Real GDP YpYp AS Price Level (a) Output and Price Level AD 1 Y1Y1 Fall in autonomous expenditure shifts AD, income and output fall. P1P1

©2007 McGraw-Hill Ryerson Ltd.Chapter (b) The Government Budget Fiscal Policy and Aggregate Demand 0 SBB 1 Real GDP Budget Balance BB- YpYp BB+ SBB 0 Y1Y1 BB(Y 1 ) BB 0 BB 1 Income and Output fall, automatic stabilizers reduce BB. Discretionary fiscal policy to offset a recessionary gap reduces structural budget balance.

©2007 McGraw-Hill Ryerson Ltd.Chapter Fiscal Policy and Aggregate Demand P AD 0 P0P0 Real GDP YpYp AS Price Level (a) Output and Price Level AD 1 Y1Y1 AD shifts back, Y shifts back to potential GDP P1P1

©2007 McGraw-Hill Ryerson Ltd.Chapter Fiscal Policy and the Public Debt BB = tY – G - iPD –iPD, annual interest paid on the outstanding public debt PBB = tY - G –PBB, primary budget balance, excludes interest payments on the public debt. SPBB = tY P - G –SPBB, structural primary budget balance BB = SPBB 0 – t 0 (Y - Y P ) - iPD

©2007 McGraw-Hill Ryerson Ltd.Chapter Budget Balances and Outstanding Debt ΔPD = -BB –An overall budget surplus reduces the public debt outstanding in the next year. –A budget deficit, increases it.

©2007 McGraw-Hill Ryerson Ltd.Chapter The Effects of Monetary Policy on AD Monetary policy affects the position of the AD curve. M = M 0 –  (Y – Y P ) –The bank reacts to short-run differences between actual and potential output by setting the nominal money supply

©2007 McGraw-Hill Ryerson Ltd.Chapter Monetary Policy and Potential Output P AD 0 P0P0 YpYp AS 0 Price Level (a) Short Run Output and Price AD 1 Y1Y1 A rise in aggregate expenditure shifts AD P1P1

©2007 McGraw-Hill Ryerson Ltd.Chapter Monetary Policy and Potential Output M0M0 Real GDP YpYp Nominal Money Supply (b) Monetary Policy Y1Y1 Bank lowers money supply M1M1 M = M 0 –  (Y – Y P ) M = M 1 –  (Y – Y P )

©2007 McGraw-Hill Ryerson Ltd.Chapter Monetary Policy and Potential Output P AD 0 P0P0 YpYp AS 0 Price Level (a) Short Run Output and Price AD 1 Y1Y1 The new monetary policy shifts AD back. P1P1

©2007 McGraw-Hill Ryerson Ltd.Chapter Interaction between Monetary and Fiscal Policy There are two ways to increase AD 1.Expansionary fiscal policy and tight monetary policy –Crowding out effect 2.Tight fiscal policy and easy monetary policy

©2007 McGraw-Hill Ryerson Ltd.Chapter Recent Economic Performance and Policy in Canada Output Gap (%) Unemployment rate (%) Inflation rate (%) Public debt/GDP (%) Real overnight rate (%) Structural primary budget balance ($ billion)

©2007 McGraw-Hill Ryerson Ltd.Chapter 1126 Chapter Summary Aggregate demandAggregate demand is the relationship between the general price level and equilibrium real GDP. equilibrium aggregate expenditureAggregate demand integrates the explanation of equilibrium aggregate expenditure, the money and financial markets, monetary policy and fiscal policy into a price/output function. its control and setting of the money supplyCentral bank conduct monetary policy using its control and setting of the money supply. the slope and position of ADHow to determine the slope and position of AD.

©2007 McGraw-Hill Ryerson Ltd.Chapter 1127 Chapter Summary Short-run aggregate supplyShort-run aggregate supply short-run equilibrium real GDP and priceAD and AS determine short-run equilibrium real GDP and price. Monetary policyMonetary policy is a demand management tool. Fiscal policyFiscal policy is a demand management tool. mix of monetary and fiscal policyThe mix of monetary and fiscal policy is important. control of inflation reduction of the public debtIndicators of monetary and fiscal policy show that in the past 20 years Canadian policy was primarily concerned with the reduction and control of inflation and with control and reduction of the public debt.