1 of 23 © 2014 Pearson Education, Inc. CHAPTER OUTLINE 13 Policy Effects and External Shocks in the AD/AS Model Fiscal Policy Effects Fiscal Policy Effects in the Short Run Fiscal Policy Effects in the Long Run Monetary Policy Effects Shape of the AD Curve When the Fed Cares More about the Price Level than Output What Happens When There is a Zero Interest Rate Bound? Shocks to the System Cost-Push Inflation Demand-Pull Inflation Monetary Policy since 1970 Inflation Targeting Looking Ahead

2 of 23 © 2014 Pearson Education, Inc. Both net taxes T (taxes minus transfer payments) and government spending G are important fiscal policy instruments. Earlier, we learned that the tax multiplier is smaller in absolute value than is the government spending multiplier. An expansionary fiscal policy (a decrease in net taxes and/or an increase in government spending) increases output (Y). Both result in a RIGHT shift of the AD curve. A contractionary fiscal policy (an increase in net taxes and/or a decrease in government spending) decreases output (Y). Both result in a LEFT shift of the AD curve. Fiscal Policy Effects in the Short Run

3 of 23 © 2014 Pearson Education, Inc. Case 1: A Right Shift of the AD Curve When the Economy is on the Almost Flat Part of the AS Curve There is an increase in output with little increase in the price level. When the economy is producing on the nearly flat portion of the AS curve, firms are producing well below capacity, and they will respond to an increase in demand by increasing output much more than they increase prices. This is the case where an expansionary fiscal policy works well.

4 of 23 © 2014 Pearson Education, Inc. The output multiplier is close to zero. Output is initially near full capacity, and attempts to increase it further lead to a higher price level. With a higher price level (inflation), the Fed, to control inflation, decreases money supply (thus increases the interest rate). There is crowding out of planned investment. Here, an expansionary fiscal policy does not work well. Case 2: A Right Shift of the AD Curve When the Economy is Operating at or near Full Capacity

5 of 23 © 2014 Pearson Education, Inc. Fiscal Policy Effects in the Long Run The long-run AS curve is vertical. Fiscal policy will have no effect on output (fiscal policy is useless) in this case if wages adjust fully to match higher prices. How fast and to what extent wages adjust to changes in prices? If wages are slower to adjust, the AS curve keeps an upward slope for a long period and fiscal policy is useful. How fast and to what extent wages adjust to changes in prices is what economists debate and have different opinions on.

6 of 23 © 2014 Pearson Education, Inc. Monetary Policy Effects Money supply (and thus the interest rate value) that Fed chooses is THE important monetary policy instrument. An expansionary monetary policy (an increase in money supply) increases output (Y), resulting in a RIGHT shift of the AD curve. A contractionary monetary policy (a decrease in money supply) decreases output (Y), resulting in a LEFT shift of the AD curve.

7 of 23 © 2014 Pearson Education, Inc. Case 1: A Shift of the AD Curve When the Economy is on the Almost Flat Part of the AS Curve There is an increase in output with little increase in the price level. When the economy is producing on the nearly flat portion of the AS curve, firms are producing well below capacity, and they will respond to an increase in demand by increasing output much more than they increase prices. This is the case where an expansionary monetary policy works well.

8 of 23 © 2014 Pearson Education, Inc. Output is initially close to capacity, and attempts to increase it further mostly lead to a higher price level. With a higher price level (inflation), the Fed, to control inflation, decreases money supply (thus raises the interest rate), and in this case, there is almost complete crowding out of planned investment. Here, an expansionary monetary policy does not work well. Case 2: A Shift of the AD Curve When the Economy is Operating at or near Full Capacity

9 of 23 © 2014 Pearson Education, Inc. AD is Relatively Flat When the Fed Cares More About the Price Level than Output The Fed cares about (1) stable prices and (2) output/income (and many others). Suppose the Fed worries more about the price level than output. In this case, when the Fed sees a price increase, it responds with a large decrease in money supply (thereby a large increase in the interest rate) and leads to a left shift of the AD curve. The AD curve is relatively flat, as the Fed is willing to accept large changes in Y to keep P stable.

10 of 23 © 2014 Pearson Education, Inc. What Happens When There is a Zero Interest Rate Bound? The Fed affects AD via a change in money supply, which leads to a change in the interest rate and thereby the planned investment. However, the interest rate cannot be below zero. Zero Interest Rate Bound The interest rate cannot go below zero. Once the interest rate is zero, an increase in money supply fails to lower the interest rate futher, which renders monetary policy to become void (useless).

11 of 23 © 2014 Pearson Education, Inc. The AD Curve in a Zero Interest Rate Binding Situation. The AD curve becomes vertical when the interest rate has reached zero. Changes in government spending (G) and net taxes (T) still shift the AD curve even if it is vertical. In fact, with a vertical AD curve, fiscal policy can be used to increase output, but monetary policy cannot. AD Curve When Zero Interest Rate?

12 of 23 © 2014 Pearson Education, Inc. Cost-Push Inflation The LEFT shift of the AS curve lowers output and raises the price level. The extent of the changes in output and the price level depend on the shape of the AD curve. cost-push, or supply-side, inflation: Inflation caused by an increase in costs. stagflation Occurs when output is falling at the same time that prices are rising. A Negative Cost Shock

13 of 23 © 2014 Pearson Education, Inc. Demand-Pull Inflation A rise in consumer confidence—can be thought of as a “demand-side shock.” Instead of being triggered by a fiscal or monetary policy change, the demand increase is triggered by something outside of the model. Any price increase that results from a demand-side shock is also considered demand-pull inflation. demand-pull inflation Inflation that is initiated by an increase in aggregate demand.

14 of 23 © 2014 Pearson Education, Inc. Inflation Targeting inflation targeting When Central Bank chooses its money supply (thus, interest rate values) with the aim of keeping the inflation rate constant or within some specified band over some specified horizon. There has been much debate about whether inflation targeting is a good idea. It can lower fluctuations in inflation, but possibly at a cost of larger fluctuations in output.

15 of 23 © 2014 Pearson Education, Inc. binding situation cost-push, or supply-side inflation demand-pull inflation inflation targeting stagflation zero interest bound R E V I E W T E R M S A N D C O N C E P T S