Macroeconomic problems and policies
Professional Development Course in Knowledge Enrichment for
Senior Secondary Economics Teachers
Outline of Lecture 4 - Macroeconomics: Macroeconomic problems and policies
Topics covered:
I.
I.
II.
III.
How fiscal policy influences aggregate demand (Output and price level)
How monetary policy influences aggregate demand (Output and price level)
Monetary policy
IV.
Inflation and deflation (quantity theory of money)
How fiscal policy influences aggregate demand (Output and price level)
Fiscal policy refers to the government’s choices regarding the overall level of
government purchases or taxes.
 Marginal Propensity to Consume (MPC), Marginal Propensity to Save (MPS)
 Fiscal policy

Definition of budget surplus: an excess of tax revenue over government
spending (T>G).

Definition of budget deficit: a shortfall of tax revenue from government
spending (G>T).

Definition of balanced budget: tax revenue equals government spending
(G=T).
 Changes in government purchases

An increase in government purchases  shifts the aggregate-demand
curve to the right

A decrease in government purchases  shifts the aggregate-demand
curve to the left
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Macroeconomic problems and policies
 The multiplier effect
Definition of multiplier effect: the additional shifts in aggregate demand that
result when expansionary fiscal policy increases income and thereby increases
consumer spending.
The Multiplier Effect
Price
*
An increase in government purchases
of $20 billion initially increases
aggregate demand by $20 billion but
the multiplier effect can amplify the
shift in aggregate demand.
$20 billion
AD3
AD2
AD1
Quantity
0
 A formula for the spending multiplier
multiplier = 1/ (1- MPC)
 The Balanced Budget Multiplier
The balanced budget multiplier is the magnification effect on aggregate
demand of a simultaneous change in government expenditure and taxes that
leaves the budget balance unchanged.
 The crowding out effect
Definition of crowding-out effect: the offset in aggregate demand that results
when expansionary fiscal policy raises the interest rate and thereby reduces
investment spending.
2
Macroeconomic problems and policies
The Crowding-Out Effect
(a) The Money Market
Interest
Rate
(b) The Shift in Aggregate Demand
Price
Level
MS
$20 billion
r2
AD2
r
AD3
M D2
AD1
MD
0
Quantity fixed
Qs
by the Fed
Quantity
of Money
0
1. An increase in government purchases increases aggregate demand (AD1  AD2),
2. the increase in spending increases money demand (MD1  MD2),
3. the equilibrium interest rate increases (r1  r2),
4. it partly offsets the initial increase in aggregate demand (AD2  AD3)
 Changes in taxes

If the government reduces taxes
 households will spend more,
 the aggregate-demand curve shifts to the right.

If the government raises taxes
 household will spend less,
 the aggregate-demand curve shifts to the left.

The size of the shift in the aggregate-demand curve depends on the sizes
of the multiplier and crowding-out effects.

A permanent tax change will have a larger effect on aggregate demand
than a temporary one.
3
Quantity
of Output
Macroeconomic problems and policies
II. How monetary policy influences aggregate demand (Output and price level)
Teaching advice

Students are very interested in the way in which the central bank changes interest
rates. Review what they learned about the central bank and its tools to change the
money supply.

The effects of monetary policy are easy to show graphically. Begin with money
supply, money demand, and an equilibrium interest rate. Show how both an
increase and a decrease in the money supply affect interest rates.
Definition of theory of liquidity preference: Keynes’s theory that the interest rate
adjusts to bring money supply and money demand into balance.
Teaching advice

Point out that when we discuss the "interest rate", we are discussing both the
nominal interest rate and the real interest rate because we are assuming that they
will move together.
Equilibrium in the Money Market
Interest
Rate
1. If the interest rate is higher than the equilibrium interest rate,
2. the quantity demanded of money is less than the quantity supplied of
money which is fixed by the central bank,
3. people will try to buy bonds or deposit funds in an interest bearing
account,
4. this increases the funds available for lending, pushing interest rates
down.
Money
supply
Excess Supply of Money
r1
Equilibrium
interest rate
Money
demand
0
Md
Qs fixed
Quantity
by the Fed
4
Quantity of
Money
Macroeconomic problems and policies
Equilibrium in the Money Market
1. If the interest rate is lower than the equilibrium interest rate,
2. the quantity demanded of money is more than the quantity supplied of money
which is fixed by the central bank,
3. people will try to sell bonds or withdraw funds in an interest bearing account,
4. this decreases the funds available for lending, pushing interest rates up.
Interest
Rate
Money
supply
Equilibrium
Interest rate
r2
Money
demand
Excess Demand of Money
0
M2d
Quantity fixed
Qs
by the Fed
Quantity of
Money
The Downward Slope of the Aggregate-Demand Curve (Keynes’s interest-rate effect)
1. Price level
(P1  P2) Quantity of money that people need to hold
2. Demand for money
 Money demand curve shifts to the right (MD1  MD2)
to balance the supply and demand for money (r1  r2)
3. Interest rate
 Cost of borrowing
(Investment
) & Return on saving
(Consumption
)
 Quantity of goods and services demanded in the economy
4. GDP
(Y1  Y2)
The Money Market and the Slope of the Aggregate-Demand Curve
(a) The Money Market
Interest
Rate
(b) The Aggregate-Demand Curve
Price
Level
Money
supply
P2
r2
r
P
MD2 at P2
MD1 at P1
0
Qs
AD
0
Quantity
of Money
5
Y2
Y
Quantity
of Output
Macroeconomic problems and policies
III. Monetary policy
 Meaning of monetary policy
Monetary policy is changes in interest rates and the quantity of money in the
economy.
 Concept of monetary base/ high powered money

currency + bank reserve deposits

controlled by the central bank
Factors affecting the monetary base
Effect on
Monetary Base
Factor
Effect on
Money Supply
Open Market Purchase
Open Market Sale
Increase in discount
window borrowing
Increase in the
discount rate
 Effect of monetary policy on the level of output and price

Changes in the Money Supply
1. Supply of money
2. Interest rate
 Money supply curve shifts to the right (MS1  MS2)
(r1  r2)
 Cost of borrowing & Return to saving
 Investment & Consumption
3. Quantity of goods and services demanded
 Aggregate-demand curve shifts to the right (AD1  AD2)
6
Macroeconomic problems and policies
A Monetary Injection
(b) The Aggregate-Demand Curve
(a) The Money Market
Interest
Rate
MS
Price
Level
MS2
r
P
r2
AD2
Money demand
at price level P
AD
0
Quantity
of Money
0
Y
Y
Quantity
of Output
 Discussion about the role of interest rate targets in central bank policy
 Case Study: Why the central bank watches the stock market (and vice versa)
Stock market booms  households become wealthier  consumer spending
 It becomes attractive for firms to issue new shares of stock
 Investment spending
 Since one of the central bank’s goals is to stabilize AD
 The central bank may lower the supply of money & raise the interest rates
 Stocks become less attractive because (i) alternative assets (such as bonds)
pay higher interest rates, (ii) the expected profitability of firms is lowered
IV. Inflation and deflation (quantity theory of money)
 Definition of inflation and deflation
Inflation - Persistent increases in the general level of prices.
Deflation - Persistent decreases in the general level of prices.
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Macroeconomic problems and policies
 Relationship between nominal and real interest rates
Definition of nominal interest rate: the interest rate as usually reported
without a correction for the effects of inflation.
Definition of real interest rate: the interest rate corrected for the effects of
inflation.
real interest rate = nominal interest rate – expected inflation rate
 Redistributive effects – Unexpected inflation and deflation

Arbitrary Redistributions of Wealth
Because inflation is often hard to predict, it imposes risk on both
borrowers and lenders that the real value of the debt will differ from that
expected when the loan is made.
 Inflation and Quantity Theory of Money
Definition of quantity theory of money: a theory asserting that the quantity of
money available determines the price level and that the growth rate in the
quantity of money available determines the inflation rate.

Definition of velocity of money (V): the rate at which money changes
hands.

To calculate velocity, we divide nominal GDP by the quantity of money.
velocity = nominal GDP / money supply

Definition of quantity equation: the equation M × V = P × Y, which
relates the quantity of money (M), the velocity of money (V), and the
dollar value of the economy’s output of goods and services (PY).
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