Fiscal and Monetary Policy With A Goods and Services Market AND Money Market Lecture 18 Jennifer P. Wissink ©2015 Jennifer P. Wissink, all rights reserved. March 25, 2015

u M s  r  I d  AE d  Y –M D  r  I d  AE d  Y u Finally: get a new lower r* and higher Y* u Note: with feedback effect, there is a smaller final change in r* and Y* u So, efficacy of monetary policy depends on some important sensitivities! An INCREASE in M S (Fed buys up bonds via OMO)

An INCREASE in G u G  AE d  Y –M D  r  I d  AE d  Y u Finally… get a new higher r* and higher Y* u Note: with feedback effect, there is a smaller final change in Y*

Issue: The Crowding-Out Effect of Expansionary Fiscal Policy u The crowding-out effect is the tendency for increases in government spending to cause reductions in private investment spending. u The crowding-out effect depends on the sensitivity or insensitivity of planned investment spending to changes in the interest rate and the sensitivity or insensitivity of money demand to changes in Y and the interest rate. u So, efficacy of fiscal policy depends on some important sensitivities!

i>clicker question Suppose the fiscal guys decide to stimulate the economy by increasing $G. Suppose the monetary guys (Janet Yellen, inter alia) want to help out in any way they can to make the fiscal guys look good. So, they would... A.sit on their hands. B.buy up government securities from the public. C.sell government securities to the public. D.decrease taxes. E.increase the discount rate.

An INCREASE in G with Accommodation by the Fed u G  AE d  Y –M D  r  I d  AE d  Y

Issue: Fed Accommodation of Fiscal Policy (of an Expansionary Fiscal Policy, in this case) u An expansionary fiscal policy (higher government spending or lower taxes) will increase aggregate output (income). u In turn, higher income will shift the money demand curve to the right, and put upward pressure on the interest rate. u If the money supply were unchanged following an increase in the demand for money, the interest rate would rise. u But if the Fed were to “accommodate” the fiscal expansion, the interest rate would not rise. u Think through what would be true if the Fed accommodated a fiscal contraction?

Policy Review u Expansionary Monetary & Fiscal: –M s up  r down  I d up  AE d up  Y up »M D up  r up  I d down  AE d down  Y down –G up  AE d up  Y up »M D up  r up  I d down  AE d down  Y down u Contractionary Monetary & Fiscal: –M s down  r up  I d down  AE d down  Y down »M D down  r down  I d up  AE d up  Y up –G down  AE d down  Y down »M D down  r down  I d up  AE d up  Y up

The Macroeconomic Policy Mix ( M s ) Forces push the variable in different directions. Without additional information, we cannot specify which way the variable moves. ?: Variable decreases. : Variable increases. : Key: Y, r ?, I ?, C Y ?, r, I, C ? Contractionary MONETARY POLICY ( M s ) Y?, r↓, I↑, C?Y↑, r?, I?, C↑Expansionary Contractionary ( G or T) Expansionary ( G or T) FISCAL POLICY

The Model with the Keynesian Cross and Money Market u Goods and Services Market: –C = f(Y d ) with C varying directly with Y d »Y d = Y – Taxes u Exogenous lump sum taxes  Taxes = Tbar u Non lump sum  Taxes = Tbar + tY where t is the marginal tax rate –I d = f(r) with I d varying indirectly with r –G is exogenous – let’s leave it that way –EX are exogenous – let’s leave them that way –IM are exogenous or some function: IM=Fbar+f(Y) or IM=Fbar+f(Y d ) u PRACTICE getting all the multipliers with variations of the equations! u Money Market: –M D = f(r, Y, PL) »with M D varying indirectly with r (a movement along) »With M D varying directly with Y and PL (a shift) –M S if fixed by the Fed u Reminder about “sensitivities”

An INCREASE in G u G  AE d  Y –M D  r  I d  AE d  Y Y AE d r M r IdId 45° help

Practice Problem Solving given A MODEL. Suppose you are given the following: C = consumptionG = govern. spendingM D = money demand I d = investment spendingT = taxesM S = money supply Y = national income/outputr = interest rateY d =disposable income C = Y d ; I d = 1000 – 1500r ; G=100; T=100; EX=0; IM=0 Money demand: M D = 900 – 1000r; The required reserve ratio for all banks in this economy is rrr=10%. No bank holds excess reserves, and everybody keeps all their money in the banking system (so no currency). The total reserves in the banking system are TR=$80. With all that, answer the following: 1. What is the total money supply? 2. What is the equilibrium interest rate? 3. What is the equilibrium level of national income? NOW Suppose: Y FE =$5, Should the FED buy or sell securities to achieve this goal? How much (give a dollar figure) should the FED buy or sell?

Try MORE! u Same set up, but now assume Y FE =$6,500 u Add an import function... and do the problem over. u Make the tax function more interesting...and do the problem over. u How about FISCAL policy instead of monetary... and do the problem over.