1. Fiscal & Monetary Policy with a Goods & Services Market & Money Market Lecture 18 Jennifer P. Wissink ©2015 Jennifer P. Wissink, all rights reserved. October 27, 2015

2. The Goods & Services Market (AE d ) & The Money Market u From Money Market we get r* where M D (r, Y, PL) = M S u From G&S market we get Y* where Y* = AE d = C(Y d )+I d (r)+G+EX–IM u Note: –I d depends negatively on the interest rate, r. »Why? When r increases, investment projects have lower present value and look less attractive. u Recall: –M D depends positively on Y&PL and depends negatively on r. u Now we have ties (r, Y and PL) that bind the Money Market to the Goods and Services Market!

3. The Goods & Services Market (AE d ) & The Money Market & POLICY (both Monetary and Fiscal) u There are equilibrium values of Y*, output(income), & the interest rate, r*, that are consistent with the existence of equilibrium in both markets, simultaneously. u Now POLICY is more complicated and interesting –Suppose Y* < Y FE  expansionary policy considered »monetary and/or fiscal –Suppose Y* > Y FE  contractionary policy considered »monetary and/or fiscal

4. Expansionary Policy u Expansionary fiscal policy is either an increase in government spending and/or a reduction in net taxes aimed at increasing Y* u Expansionary monetary policy is an increase in the money supply aimed at increasing Y* –Sometimes called “easy monetary policy”

5. Contractionary Policy u Contractionary fiscal policy is either a decrease in government spending and/or an increase in net taxes aimed at decreasing Y* u Contractionary monetary policy is a decrease in the money supply aimed at decreasing Y* –Sometimes called “tight monetary policy”

6. An INCREASE in M S (Fed buys up bonds via OMO) 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! 45° help

7. 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* 45° help

8. 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!

9. 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 and do nothing. B.buy government securities. C.sell government securities. D.decrease taxes. E.increase the discount rate.

10. 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 What would be true if the Fed accommodated a fiscal contraction?

11. u G  AE d  Y –M D  r  I d  AE d  Y Y AE d r M r IdId 45° help An INCREASE in G with Accommodation by the Fed

12. 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

13. 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

14. 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” mattering.

15. How Sensitivity Impacts Efficacy u G  AE d  Y –M D  r  I d  AE d  Y Y AE d r M r IdId 45° help

16. 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 = 600 + 0.75Y d ; I d = 2000 – 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=$70. 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 =$9,600. 4. Should the FED buy or sell securities to achieve this goal? How much (give a dollar figure) should the FED buy or sell?