Overview-chapter 15: MP and FP:
Impacts on AD
The
supply and demand for money
including the interest-rate effect on AD
How monetary policy affects the
aggregate demand curve.
How fiscal policy affects aggregate
demand. Changes in G or T.
Arguments for and against using
policy to try to stabilize the economy.
Aggregate Demand (AD)
Many
factors influence AD, including
desired spending by households and
business firms. When desired
spending changes, shifts in the AD
cause short-run fluctuations in output
and employment.
Monetary and Fiscal policy can be
used to stabilize the economy during
these fluctuations. Offset shifts.
How Monetary Policy Influences
Aggregate Demand
 The
Aggregate Demand curve is downward
sloping due to three effects:
– Pigou’s Wealth Effect
– Keynes’s Interest-Rate Effect
– Real Exchange-Rate Effect
 Of these three effects, Keynes’s InterestRate Effect and the x-rate effect are most
important.
 These 2 effects are influenced by MP.
Theory of Liquidity Preference (LP):
Keynes’s theory: The development of interest rates
 LP
where liquidity refers to liquid assetsmoney is the most liquid.
 The Liquidity Preference Theory (MD) of
interest rates states that “...market rates of
interest adjust to balance the supply and
demand for money.”
 At higher interest rates you want to be less
liquid.
 Ms determined by B of C
Theory of LP
 Money
demand reflects how much wealth
people want to hold in liquid form-as
money.
 For simplicity, suppose household wealth
includes only two assets:
– Money – liquid but pays no interest--OC
– Bonds – pay interest but not as liquid
A
household’s “money demand” reflects its
preference for liquidity.
 The variables that influence money
demand:
Y, r, and P.
Theory of Liquidity Preference:
The Supply and Demand for Money
The
Money Supply is controlled by the
B of C, which alters the money supply
in three ways:
–
–
–
Open-Market Operations
Changing the Overnight Rate
Buying and selling Canadian dollars in the market for
foreign-currency exchange
The
quantity of money supplied in the
economy is fixed at whatever level the
B of C decides to set it.
Theory of Liquidity Preference:
The Supply and Demand for Money
Because
the money supply is fixed by
the B of C it does not depend on the
interest rate.
The fixed money supply is represented
by a vertical supply curve.
The Money Market
Interest
Rate
Money Supply
QFixed
Quantity of Money
Theory of Liquidity Preference:
The Supply of Money
By
using Open-Market Operations the
B of C can shift the vertical money
supply curve left or right.
If the B of C buys government bonds:
–
Bank reserves increase and the money
supply increases.
If
the B of C sells government bonds:
–
Bank reserves decrease and the money
supply declines.
The Money Market
Interest
Rate
Money Supply
If the B of C
buys
government
bonds, money
supply
increases.
QFixed
Quantity of Money
Theory of Liquidity Preference:
The Supply and Demand for Money
Money
Demand is determined by
several factors. However, the most
important is the interest rate.
MD= f (Y, r, P)
 “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 for liquidity)
Theory of Liquidity Preference:
The Supply and Demand for Money
The
primary opportunity cost of having
the convenience of holding money is
the interest income that one gives up
when one holds cash or chequing
account balances.
An increase in the interest rate raises
the cost of holding money and thus
reduces the quantity of money
balances people wish to hold.
The Money Market
Interest
Rate
Money Demand
I0
Q0
Quantity of Money
Equilibrium in the Money Market
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.
–
Equilibrium in the Money Market
Interest
Rate
Money Supply
Money Supply and
Money Demand are
equal at the equilibrium
interest rate.
IE
Money Demand
QFixed
Quantity of Money
Theory of Liquidity Preference and
the Aggregate Demand Curve
 The
general price level of all goods and
services in the economy influences the
money demand and interest rates:
– A higher price level raises money demand
(i.e. a shift in the money demand curve.)
– Higher money demand leads to a higher
interest rate.
– Higher interest rates reduce the quantity
of goods and services demanded (AD).
Theory of Liquidity Preference and
the Aggregate Demand Curve
 As
interest rates increase, the cost of
borrowing and the return to saving is
greater. Fewer households and firms
borrow money, leading to a decrease in
spending. Especially Investment spending.
 An increase in the price level causes the
real exchange rate to increase and net
exports to fall.
 The end result is a negative relationship
between the price level and the AD.
Aggregate Demand Curve and RXR
 In
an open economy, the other important
influence is the real exchange-rate (RXR) effect.
– An increase in the price level causes the real
exchange rate to increase
– Canadian-produced goods are more expensive
relative to foreign-produced goods, and both
foreigners and Canadians substitute away from
Canadian-produced goods
– Canada’s net exports fall
– This is the RXR effect on slope of AD.
Changes in the Money Supply
The
B of C has control over shifts in
the aggregate demand when it
changes monetary policy. Recall:
An increase in the money supply (i.e.
buying bonds) will...
…shift the Money Supply to the right
… without a change in the Money
Demand the interest rate will fall, thus
… inducing people to hold the additional
money the B of C has created.
Changes in Money Supply
Interest
Rate
MS0 MS1
IE0
IE1
Money Demand
QFixed0 QFixed1
Quantity of Money
Closed Economy
MS
↑ >>r ↓ >>I & consumer durable
spending ↑ --shifts Ad so Y ↑
This is expansionary MP.
However as Y ↑, this increases MD
This partially reverses r ↓
Overall AD shifts right.
For open economy this is reinforced
by RXR ↓ because Rc <Rw
Increasing MS-closed economy
Small Open Economy
Considerations-MP
A
monetary injection by the B of C
lowers interest rates.
If rc<rw, savers from LF sell C$ and
buy ROW. Increases supply of C$ in fx
This causes the dollar to depreciate,
which causes net exports to rise
shifting the AD curve to the right.
 AD
shifts farther right than in closed econ.
SOE--MP
NX
and GDP increase so MD increases
driving rc back up to rw.
Major policy effect is through x-rate
decline.
The B of C must allow the exchange
rate to vary freely if its desire is to
change the money supply.
 MP
more effective because of NX effect
MP-Open Economy
How Fiscal Policy Influences
Aggregate Demand
 Fiscal
policy refers to the government’s
choices regarding the overall level of
government purchases or taxes.
 Fiscal policy influences saving, investment,
and growth in the long-run. In the shortrun, fiscal policy affects aggregate demand.
 FP—expansionary
and contractionary: ∆G&T
Changes in G and T
The
federal government can influence
the economy because
of the size of the central government in
relation to the economy and other
economic entities.
– of the deliberate use of spending and
taxes to manipulate the economy toward
achieving a predetermined outcome.
–
MP overview
MS
↑ >>r ↓ >>I & consumer durable
spending ↑ --shifts AD right so Y ↑
This is expansionary MP.
However as Y ↑, this increases MD
This partially reverses r ↓
Overall AD shifts right.
For SOE this is reinforced by RXR ↓
because Rc <Rw—Supply C$ ↑
Changes in G and T--FP
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.
–
–
Expansionary FP is intended to shift AD right.
Changes in Government Purchases
There
are two macroeconomic effects
from government purchases-- ∆G:
1.The Multiplier Effect: SPENDING.
2.The Crowding-Out Effect: Interest rates
Crowding out in 2 reduces the effect of 1
The Multiplier Effect of
Government Purchases
 Each
dollar spent by the government can
raise the aggregate demand for goods and
services by more than a dollar--- a multiplier
effect.
 The total impact of the quantity of goods
and services demanded can be larger than
the initial impulse from higher government
spending. BECAUSE of re-spending—FIRM
& its workers.
Spending Multiplier 378-9
G
spends $5000
 Owners and workers receive $5,000
 MPC = ∆C/ ∆Y Eg get $10: spend 8& save 2
MPC
is 0.8 (MPS=0.2)
1st Extra spending is 0.8*$5000= $4000
$4000 is income where spent.
They spend 0.8*4000= $3200 etc
Respending gets smaller>>>>>>
Spending Multiplier
 The
formula for the multiplier is:
Multiplier (k) = 1 ÷ (1 - MPC)
MPC
is the Marginal Propensity to
Consume.
MPC

=  C/ Y Extra C from extra Y
IF MPC= 0.8, k=5
$5000+4000+3200+2560+-----$25,000
is k*5000
=$25,000
The Multiplier Effect
Price
Level
An increase in
government
purchases initially
increases AD
AD1
AD2
Quantity of Output
The Multiplier Effect
Price
Level
The multiplier effect
can amplify the shift
in AD
AD3
AD1
AD2
Quantity of Output
The Crowding-Out Effect
 An
increase in government purchases
causes the interest rate to rise (MD shifts
right) , and a higher interest rate tends to
choke off the demand for goods and
services.
 G competes for LF raising r and reducing I
 The reduction in demand that results when
a fiscal expansion raises the interest rate is
called the crowding-out effect.
 Opposite direction to multiplier.
Crowding out by G—MD increases
Crowding out
An
increase in G increases spending
and MD causing interest rates to rise.
The higher interest rates cause
interest-sensitive spending (I) to go
down and this reduction in demand is
called crowding out.
Crowding out effects
When
G increases its purchases (eg)
by $20B, the aggregate demand for
goods and services could rise by more
or less than $20B depending on
whether the multiplier effect or the
crowding out effect is larger.
FP-Open Economy
Rc=Rw
Initially
more G increases Rc--MD
Increases demand for C$ (Rc>Rw)
C$ appreciates
NX falls
FP crowds out NX
Open Economy FP-x rate flexible:
No lasting effect on AD
Changes in Taxes
When
–
the government cuts taxes, it:
Increases households’ take-home pay.
This results in households saving some
of the additional income---MPS
Households will spend some on
consumer goods---MPC.
This shifts the aggregate-demand curve
to the right. Like G spending.
Changes in Taxes
The
size of the shift in aggregate
demand resulting from a tax change is
also affected by the multiplier and
crowding-out effects.
The duration of the shift in the
aggregate demand is also determined
by the B of C’s policy for the exchange
rate (fixed or flexible). NX effect.
SOE
In
a small, open economy, an
expansionary fiscal policy (∆G or ∆ T)
causes the dollar to appreciate. Since
this causes net exports to fall, there is
an additional crowding-out effect that
reduces the demand for Canadian
produced goods and services.
Using Policy to Stabilize the Economy
 Many
policy-makers believe it necessary to
use monetary and fiscal policy to achieve
any level of aggregate demand and GDP
that they wish.
–
–
Active monetary and fiscal intervention is
necessary to tame an inherently unstable
private sector.
The use of policy instruments stabilizes
aggregate demand and production and
employment.
Using Policy to Stabilize the Economy
The
use of government tax and
spending policies to stabilize
economic ups and downs in the shortrun is called discretionary fiscal policy.
Generally, those that accept this
approach to short-run economic
stabilization follow the Keynesian
theory of the economy.
Using Policy to Stabilize the Economy
 Some
economists argue that the
government should avoid using monetary
and fiscal policy
 Policy may make it worse.
 The economy can be left to deal with shortrun fluctuations on its own.
 Discretionary Fiscal policy affects the
economy with substantial lags. Effect?
 Others: Use MP only-especially SOE.
Automatic Stabilizers
Automatic
Stabilizers are changes in
fiscal policy that stimulate aggregate
demand when the economy goes into a
recession without policy-makers
having to take any deliberate action.
Automatic stabilizers include:
The Tax System: Y↓ >>T ↓
– Government Spending---EI especially
– Flexible X rate.
–
X Rate as Automatic Stabilizer
A
U.S. recession would cause Canadian net
exports to fall, lowering aggregate demand
 However, with flexible exchange rates
– Lower Canadian GDP results in lower money
demand, reducing the interest rate below the
world interest rate
– Decreased demand for Canadian assets results
in depreciation of the Canadian dollar, making
Canadian-produced goods relatively less
expensive
– Net exports rise
The Economy in the Long-Run and
Short-Run
When
thinking about the long-run
economy the Loanable Funds Theory
is used to best describe the changes
that occur. Rc=Rw S=I
When thinking about the short-run
economy, the Liquidity-Preference
Theory is used to best describe the
changes that occur. ∆Ms>> ∆R>> ∆ Y
The Economy in the Long-Run and
Short-Run
In
the Long-Run:
Output is determined by the supplies of
capital and labour and the available
production technology. LAS--PPF
– In a closed economy, the interest rate
adjusts to balance the supply and
demand for loanable funds.
– The price level adjusts to balance the
supply and demand for money.
–
The Economy in the Long-Run and
Short-Run
In
the Short-Run:
The price level is stuck at some level and
is relatively unresponsive to changing
economic conditions. “sticky prices”
– The interest rate adjusts to balance the
supply and demand for money. Keynes
– The level of output responds to changes
in the aggregate demand (AD) for goods
and services. On SRAS left of LAS.
–
Conclusion
Government
macroeconomic policy
should proceed carefully and with an
understanding of the consequences of
its policies in the short and long-run.
Fiscal policies can have long-run
effects on saving, investment, the
trade balance and growth. Crowding.
Monetary policy can ultimately
determine the level of prices and affect
the inflation rate.
Question on fp
The economy is in recession.
Shifting the AD curve rightward by $200B
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should the government increase G
to end the recession?
B. If there is crowding out, will the government
need to increase G more or less than this
amount?
Fp-multiplier
The economy is in recession.
Shifting the AD curve rightward by $200B
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should the government increase G
to end the recession?
Multiplier = 1/(1 – .8) = 5
Increase G by $40B
to shift AD by 5 x $40B = $200B.
Crowding out
The economy is in recession.
Shifting the AD curve rightward by $200B
would end the recession.
B. If there is crowding out, will the government need to
increase G more or less than this amount?
Crowding out reduces the impact of G on AD.
To offset this, the government should increase G by a
larger amount.
How much more??-depends on crowding parameter.
Pdot and U rate—ch 16
How
are inflation and the
Unemployment rate related in the short
run? In the long run?
What
factors alter this relationship?
Especially how dies this relate to AD,
SRAS AND LAS?
What
is the short-run cost of reducing
inflation?
What we will show
 In
the long run, inflation & unemployment are
unrelated: Neutrality.
– The inflation rate depends mainly on
growth in the money supply.
– Unemployment (the “natural rate”)
depends on the minimum wage, the
market power of unions, efficiency wages,
and the process of job search. real
– SR related to cycles.—AD and SRAS.