Harcourt Brace & Company Chapter 32 The Influence of Monetary and Fiscal Policy on Aggregate Demand

Harcourt Brace & Company Economic Objectives u 1. Full-N u 2. Economic Growth u 3. Price Stability

Harcourt Brace & Company Two Problems in the Economy u Inflation u Unemployment

Harcourt Brace & Company Inflationary Gap u Yf < Ye u Normal market adjustment u In the Long-run, the economy is always at full-N

Harcourt Brace & Company Recessionary Gap u Ye < Yf u Normal Market adjustments u In the Long-run, the economy is always at full-N

Harcourt Brace & Company Government Assistance u Monetary Policy u Changing the Money Supply and interest rates to achieve macroeconomic objectives by the Fed

Harcourt Brace & Company The Supply and Demand for Money u The Money Demand is determined mostly by the interest rate. u “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.” (i.e. a desire of liquidity)

Harcourt Brace & Company The Money Market Interest Rate Quantity of Money Money Demand I0I0 Q0Q0

Harcourt Brace & Company The Money Market Interest Rate Quantity of Money Money Demand I0I0 I1I1 Q0Q0

Harcourt Brace & Company The Money Market Interest Rate Quantity of Money Money Demand I0I0 I1I1 Q1Q1 Q0Q0

Harcourt Brace & Company The Supply and Demand for Money u The Money Supply is altered in three ways by the Fed: –Open-Market Operations –Changing the Reserve Requirements –Changing the Discount Rate u The quantity of money is fixed by the Fed.

Harcourt Brace & Company The Supply and Demand for Money u Open-Market Operations can shift the Ms curve left or right. u If the Fed buys government bonds: –Bank reserves increase and the Ms increases. u If the Fed sells government bonds: –Bank reserves decrease and the Ms decreases.

Harcourt Brace & Company The Money Market Interest Rate Quantity of Money Money Supply Q Fixed

Harcourt Brace & Company The Money Market Interest Rate Quantity of Money Money Supply Q Fixed If the Fed buys government bonds, money supply increases.

Harcourt Brace & Company The Money Market Interest Rate Quantity of Money Money Supply Q Fixed If the Fed sells government bonds, money supply decreases.

Harcourt Brace & Company Equilibrium in the Money Market u By 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 exactly equals the quantity of money supplied.

Harcourt Brace & Company Equilibrium in the Money Market Interest Rate Quantity of Money Money Demand Money Supply Q Fixed IEIE

Harcourt Brace & Company Equilibrium in the Money Market Interest Rate Quantity of Money Money Demand Money Supply Q Fixed IEIE Money Supply and Money Demand are equal at the equilibrium interest rate.

Harcourt Brace & Company Changes in Money Supply Interest Rate Quantity of Money Money Demand MS 0 Q Fixed0 I E0

Harcourt Brace & Company Changes in Money Supply Interest Rate Quantity of Money Money Demand MS 0 Q Fixed0 I E0 MS 1

Harcourt Brace & Company Changes in Money Supply Interest Rate Quantity of Money Money Demand MS 0 Q Fixed0 I E0 MS 1

Harcourt Brace & Company Changes in Money Supply Interest Rate Quantity of Money Money Demand MS 0 Q Fixed0 I E0 I E1 Q Fixed1 MS 1

Harcourt Brace & Company Closing an Inflationary Gap using Monetary Policy u Ms falls, interest rates rise, and AD falls

Harcourt Brace & Company Closing a Recessionary Gap using Monetary Policy u Ms rises, interest rate falls and AD rises

Harcourt Brace & Company Discretionary Fiscal Policy u Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes to achieve macroeconomic objectives.

Harcourt Brace & Company Using Policy to Stabilize the Economy u Those that accept discretionary fiscal policy as a means to attain short-run economic stabilization follow the Keynesian theory of the economy.

Harcourt Brace & Company Federal Government Budget u The Federal government has the largest budget in the world - $1.7 billion. u General Motors, the largest corporation, has $165 billion.

Harcourt Brace & Company Changes in Government Purchases u The federal government’s control of the economy is both direct and indirect. –Its expenditures have a direct effect on aggregate spending and therefore equilibrium GDP. –Taxes and tax policy indirectly affect the aggregate spending of consumers.

Harcourt Brace & Company Closing an Inflationary Gap using Fiscal Policy u Government spending falls and/or taxes rise and AD falls.

Harcourt Brace & Company Closing a Recessionary Gap using Fiscal Policy u Government spending rises and/or taxes fall and AD rises.

Harcourt Brace & Company Changes in Government Purchases u There are two macroeconomic effects from government purchases: –The Multiplier Effect –The Crowding-Out Effect

Harcourt Brace & Company The Multiplier Effect of Government Purchases u Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar--- a multiplier effect.

Harcourt Brace & Company The Multiplier Effect Price Level Quantity of Output AD 1

Harcourt Brace & Company The Multiplier Effect Price Level Quantity of Output AD 1 AD 2 An increase in government purchases initially increases AD

Harcourt Brace & Company The Multiplier Effect Price Level Quantity of Output AD 1 AD 2 The multiplier effect can amplify the shift in AD AD 3

Harcourt Brace & Company The Multiplier Effect of Government Purchases u The formula for the multiplier is: Multiplier = 1 ÷ (1 - MPC) v the MPC is the Marginal Propensity to Consume. v MPC - how much of each additional dollar of income a household spends

Harcourt Brace & Company The Crowding-Out Effect u An increase in government purchases causes the interest rate to rise, and a higher interest rate tends to choke off the demand for goods and services. u The reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.

Harcourt Brace & Company Using Policy to Stabilize the Economy u Some economists argue that the government should avoid using monetary and fiscal policy to try to stabilize the economy. They suggest the economy should be left to deal with the short-run fluctuations on its own. u Discretionary Fiscal policy affects the economy with substantial lags.

Harcourt Brace & Company Automatic Stabilizers u 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. u Automatic stabilizes include: –The Tax System –Government Spending