IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Unit 3.4 Demand and Supply-Side Policies
Unit Overview
3.4 Demand-side and supply-side policies
Shifts in the AD curve / demand-side policies
• fiscal policy
• interest rates as a tool of monetary policy
Shifts in the AS curve / supply-side policies
Strengths and weaknesses of these policies
Blog posts: "Fiscal policy"
Blog posts: "Monetary policy"
Higher level only:
Multiplier
• calculation of multiplier
Accelerator
"Crowding out"
Money, banking, and financial markets (AP only)
• Measures of money supply
• Banks and creation of money
• Money demand
• Money market
• Loanable funds market
Blog posts: "Supply-side economics"
Blog posts: "Multiplier effect"
Central bank and control of the money supply (AP
only)
• Tools of central bank policy
• Quantity theory of money
• Real versus nominal interest rates
www.welkerswikinomics.com
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Demand-side Policies
Demand-side policies: Macroeconomic policies undertaken by a government
aimed at increasing or decreasing Aggregate Demand (total spending on goods
and services) in the economy
PL
LRAS
Fiscal policy: Changes in government
spending and/or taxation aimed at
increasing or decreasing aggregate
demand
Monetary Policy: Changes in the supply of
money by a nation's central bank aimed at
raising or lowering the prevailing interest
rates in the economy, which subsequently
affect the level of consumer and
investment spending
SRAS
Pe
AD
When would policymakers want to
implement demand-side policies?
Yfe
real GDP
NOT when an economy is producing at its fullemployment level!
If AD is excessively strong, contractionary demand-side policies can be used to
reduce spending. If AD is weak, expansionary demand-side policies can be used to
increase spending
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Supply-side Policies
Supply-side policies: Macroeconomic policies taken by a government or central bank aimed at
increasing productivity, lowering firms' costs, and increasing the level of aggregate supply in the
economy. Classical economists advocate use of supply-side policies to solve macroeconomic
problems.
Reduction in income taxes: increases incentive to work since workers get to keep more of their hard
earned wages
Reduction in corporate taxes: increases incentive to invest in new capital. An increase in the nation's
capital stock increases potential output of the economy
Reduction in trade union power: Unions fight for higher wages, which increases firms' costs. Lower
wages will lower costs to firms and increase their ability to produce more output
Reduction or elimination of minimum wages: Lower minimum wage will lower firms' costs, increasing
their potential output and aggregate supply
Reduction in unemployment benefits: Generous benefits for the unemployed reduce the incentive to
find work, reducing the supply of available labor. Fewer benefits increase supply of labor and AS
Deregulation: Burdensome regulations of business can increase costs for firms. Deregulating business
operations will lower firms' costs and increase AS
Privatization: Transferring state-run firms to the private sector may lead to greater efficiency as
firms compete to minimize costs and maximize profits
Anything that increases the quantity or the quality of productive
resources or decreases firms' costs will increase AS
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Fiscal Policy
Expansionary Fiscal Policy: An increase in government spending and/or a decrease
in taxes aimed at increasing the total amount of spending in an economy, lowering
unemployment and increasing total output and growth.
Example: the 2009 American Recovery and Reinvestment Act is a $784 spending and tax cut
package aimed at getting the US out of recession:
"In the face of an economic crisis, the magnitude of which we have not seen since the Great
Depression, the American Recovery and Reinvestment Act represents a strategic -- and
significant -- investment in our country’s future.
The Act will create or save three to four million jobs, 90 percent of them in the private
sector. It will provide more than $150 billion to low-income and vulnerable households -spurring increased economic activity that will save or create more than one million jobs.
These measures are necessary to help the millions of families whose lives have been upended
by the economic crisis. But, this Act will do more than provide short-term stimulus. By
modernizing our health care, improving our schools, modernizing our infrastructure, and
investing in the clean energy technologies of the future, the Act will lay the foundation for a
robust and sustainable 21st century economy."
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Fiscal Policy
The ARRA: How will each of the components of the ARRA lead to an increase in
Aggregate Demand, a decrease in unemployment and an increase in GDP in
America?
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Fiscal Policy
The ARRA: How will each of the components of the ARRA lead to an increase in Aggregate
Demand, a decrease in unemployment and an increase in GDP in America? What are the
potential supply-side effects of the program?
Education and training
State and local fiscal relief
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Protecting the vulnerable
Infrastructure and Science
Energy
Health Care
Tax Relief
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Fiscal Policy
The ARRA: Possible Demand and Supply-side effects
Demand-side: Jobs in
community colleges and
public school
Supply-side: more
productive and skilled
workforce
Demand-side:
relieve state budget
shortages, better
able to pay state
employees
Demand-side: Increase
purchasing power of poor
and unemployed, increase C
Supply-side: Could create
disincentive to seek
employment, shift AS left?
Demand-side:
Increased
investment in new
technologies.
Supply-side:
improve efficiency
of energy
resources,
productive
capacity of nation
Demand-side: Increased employment in
health sector. Supply-side: improved
health increases productivity of labor force
Demand-side: More disposable income
increases consumption, higher expected
returns increases investment Supply-side:
New capital makes firms and workers
more efficient, increasing nation's
productive capacity
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Demand-side: New investment and
employment by construction firms Supplyside: modern infra-structure improves
efficiency, communication, transportation
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Fiscal Policy
Expansionary fiscal policy: Graphical analysis
The problem: Low confidence and
expectations about the future cause private
C and I to fall to (AD), demand-deficient
recession and unemployment result
PL
The fix: A tax break for households and
firms, combined with new government
spending on infrastructure, education and
health, stimulate aggregate demand
The result: An increase in government
spending and higher disposable income for
households, combined with higher expected
rates of return on investments by firms
stimulate private spending in the economy.
• The initial change in G is multiplied
through successive increases in C and I.
• The ultimate increase in GDP is greater
than the initial increase in G
• Output returns close to the full
employment level
• Unemployment returns close to the NRU
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LRAS
SRAS
P1
Pe
AD2(after multiplier)
AD1(with stimulus)
AD
Ye
Yfe
real GDP
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Fiscal Policy
Expansionary fiscal policy: Supply-side effects
How will a decrease in taxes affect
PL
Aggregate Supply?
LRAS1
SRAS
• Lower business taxes will encourage
new investment in capital
• Greater capital stock increases the
nation's productive capacity
Pe
• AS may shift out
Pe1
How will an increase in Government
spending affect AS? TWO VIEWS
• If gov't invests in infrastructure, education,
health and other projects that increase
productivity of nation's resources, AS may
shift out
• If gov't spending causes interest rates to
rise, it may "crowd out" private investment
in capital and decrease the size of the nation's
capital stock, causing AS to shift left
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AD2
Yfe
Yfe1
real GDP
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Fiscal Policy
Contractionary fiscal policy: Graphical analysis
The problem: Excessive spending in the PL
economy has forced unemployment below
the natural rate and the price level up as
firms compete for scarce resources
The fix: Government cuts spending on
particular projects, increases income and
business taxes
LRAS
SRAS
Pe
P1
AD
The result: Disposable income among
households falls, reducing consumer
spending. Expected rates of returns on new
capital falls, lowering investment.
Government spending falls, reducing overall
demand in the economy
• The initial decline in G, C and I multiplies
itself through successive reductions in
spending
• The ultimate decrease in GDP is greater
than the initial decrease in G
AD1(with fiscal policy)
AD2(after multiplier)
Yfe Ye
real GDP
• Output returns close to the full employment level
• Unemployment returns close to the NRU
• Inflation returns to a stable rate
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Fiscal Policy - Spending Multiplier
Policy options - G or T? What's more effective at stimulating AD, an
increase in government spending or a decrease in taxes?
• Some economists tend to favor higher G during recessions and higher taxes during
inflationary times if they are concerned about unmet social needs or infrastructure.
• Others tend to favor lower T for recessions and lower G during inflationary periods when
they think government is too large and inefficient.
Scenario: Government wants to boost output by 200 billion dollars. Assume the
nation's MPC = .55. What should the government do, cut taxes or increase
government spending?
Spending Multiplier (K) = 1/1-MPC = 1/.45 = 2.22
ΔGDP = K x ΔSpending
200b = 2.22 (ΔSpending)
ΔSpending = 90b
To achieve $200b of GDP growth, government spending must increase by
$90b. So how large of a tax cut is needed to achieve the same change in GDP?
We must know the Tax Multiplier
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Fiscal Policy - Tax Multiplier
Tax Multiplier: A measure of the change in GDP caused by changes in
government taxes
Tax Multiplier = -MPC/MPS (or the MRL)
Tax multiplier (Tm) = -.55/.45 = -1.22
ΔGDP = Tm x ΔTaxes
200b = -1.22 (ΔTaxes)
ΔTaxes = -164b
By how much would the government have to cut taxes to achieve the desired
increase in GDP?
Answer: $164 billion
Rationale: 45% of any tax cut will go towards savings, purchase of imports or debt repayment, all
of which are leakages from the circular flow. Only 55% will turn into new spending in the economy
By how much would the government have to increase spending to achieve
the desired increase in GDP?
Answer: $90 billion
Rationale: An increase in government spending represents a direct injection into the economy, as
none of it will be leaked in the form of savings, purchase of imports or debt repayment
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Fiscal Policy
Automatic stabilizers in Fiscal Policy: Built-in stability arises because net taxes (taxes
minus transfers and subsidies) change with GDP. It is desirable for spending to rise when
the economy is slumping and vice versa when the economy is becoming inflationary.
• With a decline in national income,
government spending automatically
increases as more people collect
unemployment benefits, food stamps, and
welfare. When national income increases
government support for households and
firms is automatically rolled back, leading
to a more balanced budget
Built-in stability in fiscal policy
T
G and T (billions $)
• Tax revenues automatically increase
when national income increases because
there is more income to tax. Revenues fall
with GDP because incomes fall.
Balanced budget
G
Real GDP
• The size of automatic stability depends on responsiveness of changes in taxes to
changes in GDP:
The more progressive the tax system, the greater the economy’s built-in
stability.
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy (AP only)
Monetary Policy: Changes in the supply of money by a nation's central bank aimed at
raising or lowering the prevailing interest rates in the economy, which subsequently affect
the level of consumer and investment spending
Money comes in many forms: A nation's money supply is larger than just the amount
of paper money in circulation. It also includes less liquid forms of money.
Most liquid
M1= currency and checkable deposits: Currency (coins + paper money) held
by public.
• Is “token” money, which means its intrinsic value is less than actual value. The
metal in a dime is worth less than 10¢.
• All paper currency consists of Federal Reserve Notes issued by the Federal
Reserve.
• Checkable deposits are included in M1, since they can be spent almost as
readily as currency and can easily be changed into currency.
Qualification: Currency and checkable deposits held by the federal government,
Central Bank, or other financial institutions are not included in M1.
M2 = M1 + some near-monies which include:
• Savings deposits and money market deposit accounts.
• Certificates of deposit (time accounts) less than $100,000.
• Money market mutual fund balances, which can be redeemed by phone calls,
checks, or through the Internet.
Least liquid
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MZM = Money zero maturity, includes:
• Long-time deposits that require substantial penalties to withdraw before
maturity
• Money market mutual
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
The Money Market
The Money Market: an introduction
ir
Dt
Money Demand: the public wants to hold
money for two main reasons.
• Transactions demand, Dt: is money kept for
purchases and will vary directly with GDP. The
more output, the more money the public will
demand to buy that output
ir
Transaction demand Q
m
• Asset demand, Da: is money kept as a store of
value for later use. Asset demand varies
inversely with the interest rate, since that is the
opportunity cost of holding idle money.
Da
Asset demand
• Total Demand for Money, Dm: Total demand
will equal the sum of the total amount of money
demanded for transactions and for assets.
ir
Qm
Sm
ie
Dm
Total demand for money
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Qm
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy (AP only)
The US Federal Reserve System: Who's in charge of monetary policy in the US?
The Federal Reserve: America's Central Bank
• 12 banks located in different regions of the country
• Coordinated by the Fed's Board of Governors
• Bankers' banks: Provide banking services to commercial banks
>>accept deposits
>>lend money (called the "discount window", only if commercial banks can't
borrow from one another would they borrow from the Fed)
>>Issue new currency to commercial banks
• FOMC - Federal Open Market Committee: 12 individuals, including the Chairman of the
Fed (Bernanke). Purpuse is to buy and sell government securities to control the nation's
money supply and influence interest rates. Execute monetary policy.
Fed Functions and the Money Supply
• Issue currency: the Fed can inject new currency into the money supply by issuing Federal
Reserve Notes (dollars) to commercial banks to be loaned out to the public.
• Setting reserve reuirements: this is the fraction of checking account balances that
commercial banks must keep in their vaults. The larger the reserve requirement, the less
money commercial banks can loan out.
• Lending money to banks: The Fed charges commercial banks interest on loans, this is called
the "discount rate".
• Controling the money supply: this in turn enables the Fed to influence interest rates.
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy (AP only)
Money Creation: What does it mean to create money in a modern economy?
Fractional reserve banking - How banks create money: By accepting deposits from
households, then lending out a proportion of those deposits to borrowers, which
themselves end up being deposited and lent out again and again, BANKS CREATE NEW
MONEY through their every-day activities.
A bank begins operations by accepting deposits from savers: Bank must
keep reserve deposits in its district Federal Reserve Bank.
• Banks can keep reserves at Fed or in cash in vaults.
• Banks keep cash on hand to meet depositors’ needs.
• Required reserves are a fraction of deposits, as noted above.
Other important points:
• Excess reserves: Actual reserves minus required reserves are called excess reserves. This is
the portion of total reserves that a bank is allowed to lend out.
• Control: Required reserves do not exist to protect against “runs,” because banks must keep
their required reserves. Required reserves are to give the Federal Reserve control over the
amount of lending or deposits that banks can create. In other words, required reserves help the
Fed control credit and money creation.
• Banks cannot loan beyond their required required reserves
• Asset and liability: Reserves are an asset to banks but a liability to the Federal Reserve Bank
system, since now they are deposit claims by banks at the Fed.
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy (IB and AP)
The Money Market: an introduction
Supply of money: Money supply is established by the Central Bank, it is perfectly
inelastic since it is based on policy goals
• Money supply can increase: If a central bank wishes to lower interest rates, it
can increase the supply of money in the economy by buying bonds from the public
• Money supply can decrease: If a central bank wishes to increase interest rates, it
can decrease the supply of money in the economy by selling bonds to the public
Expansionary Monetary Policy
S1
S1
Interest rate
Interest rate
S
Contractoinary Monetary Policy
5%
S
6%
5%
4%
Dmoney
Q1
Q2
Quantity of money
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Dmoney
Q2 Q1
Quantity of money
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy - OMO (AP only)
Monetary policy: the central bank's Open Market Operations
Central bank wishes to lower prevailing interest rates to encourage I and C. Central
bank must BUY government bonds on the bond market, which increases Db
The higher price of bonds on the market causes the interest rates on bonds to decrease, households
and firms want to exchange their bonds for money. The central bank takes cash from its vaults (not
part of the money supply) and buys bonds from the public. Checkable deposits and excess reserves
increase, money supply increases, interest rate in the economy falls.
Expansionary Monetary
Policy - to lower interest
rates, CB buys bonds on the
open market
P
Bond Market
for $100 T-bills
Sb
bond price: $97
interest rate: 3%
97
94
bond price: $94
interest rate: 6%
Db1
Db
Q
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Q1
Qb
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy - OMO (AP only)
Monetary policy: the central bank's Open Market Operations
The central bank wishes to increase interest rates to slow down investment and
consumption, bring inflation under control and return unemployment to the NRU
The central bank will sell government bonds that it holds to the public, which increases the
supply, lowers the price, increases the interest rate and the quantity demanded of bonds. The
public withdraws its checkable deposits and banks use some of their excess reserves to buy
bonds whose returns are more attractive. The money supply decreases and interest rates rise
in the economy.
Contractionary Monetary
Policy - to raise interest
rates, the CB sells bonds on
the open market
P
Bond Market
for $100 T-bills
bond price: $97
interest rate: 3%
97
Sb
Sb1
bond price: $94
interest rate: 6%
94
Db
Q
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Q1
Qb
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy (IB and AP)
Monetary policy: Impact on the Money Market, Investment, and AD/AS
Money Market w/
expansionary monetary policy
Investment Demand
PL
S1
Interest rate
Interest rate
S
5%
LRAS
SRAS
P1
Pe
AD2(after multiplier)
4%
ADΔI
Dmoney
DI
Q2
Q1
Q1
Money Market
Ye
Investment Demand
w/Contractoinary Monetary Policy
LRAS
S
6%
5%
Yfe
real GDP
PL
Interest rate
Interest rate
Q2
Quantity of Investment
Quantity of money
S1
AD
SRAS
Pe
P1
AD
ADΔI
AD2(after
Q2 Q
1
Quantity of money
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multiplier)
DI
Dmoney
Q2
Q1
Quantity of Investment
real GDP
YfeYe
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy - OMO (AP only)
Expansionary Monetary Policy and the Federal Funds rate: How the Fed's OMOs lead to lower
commercial interest rates
• Government bonds are held as assets by both
commercial banks and the public. Bonds are
illiquid, meaning they cannot be spent.
• Banks receive cash from the Fed, which increases
their excess reserves. Further, the public will
deposit the checks they receive from the Fed into
their banks, increasing checkable deposits, which
add to both the banks’ required reserves and
excess reserves.
• The result is banks now have new liquidity that
they want desperately to lend out in order to earn
interest
Federal Funds rate
• In order to stimulate new spending, the Fed can
take some of its reserves of money (the green bills),
and buy bonds from the public and banks.
Federal Funds Market
Sf3
4.5
Fed sells bonds, Sf
decreases, raises FF rate
Sf1
4.0
Fed buys bonds, Sf
increases, lowers FF rate
Sf2
3.5
Df
Qf3
Qf1
Qf2
Quantity of Reserves
• When banks’ reserves increase, the supply of “federal funds” shifts down, lowering the
interest rates that banks charge one another for overnight loans. Federal funds are the cash
that banks often loan to one another at the end of each day in order to meet their reserve
requirements.
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy - OMO (AP only)
Expansionary Monetary Policy and the Federal Funds rate: How the Fed's OMOs lead to lower
commercial interest rates
The Federal Funds rate and monetary policy, an example:
• Assume Bank A has finds at the end of the day that it has received more deposits than
withdrawals, and it now has $1m more in its reserves than it is required to have. Bank A wants
to lend that money out as soon as possible to earn interest on it.
• Bank B, on the other hand, received more withdrawals than it did deposits during the day, and
is $1m short of its required reserves at day’s end. Bank B can borrow Bank A’s excess reserves in
order to meet its reserve requirement.
• Bank A will not lend it for free, however, and the rate it charges is called the “federal funds”
rate, since banks’ reserves are held predominantly by their district’s Federal Reserve Bank.
• Funds at the regional Federal Reserve Bank ("federal funds") will be transferred from Bank A's
account to Bank B's account. Both banks have now met their reserve requirements, and Bank A
earns interest on its short-term loan to Bank B.
When the Fed buys bonds, all banks experience an increase in their reserves, meaning the
supply of federal funds shifts out (or down in the graph above), lowering the interest rate on
federal funds. Lower interest rates on overnight loans will encourage banks to be more
generous in their lending activity, allowing them to lower the prime interest rate (the rate they
charge their most credit-worthy borrowers), which in turn should have a downward effect on all
other interest rates.
Blog post: "Helicopter Ben and Monetary Policy: the cartoon version!"
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy - OMO (AP only)
Expansionary Monetary Policy - how it works:
CB buys bonds
from public and
banks
checkable
deposits and
bank reserves
Excess
reserves,
money
supply
Interest
rates
FF rate
GDP,
employment,
price level
AD
C, I
Central Bank
Central Bank buys
bonds from public,
increasing amount of
checkable deposits
$
$
B
$
$
$
$
B
$
B
B
B
$
Central Bank buys
bonds from banks,
injecting liquidity to
excess reserves
$
B
B
$
$
the Public
$
B
$
Commercial
Banks
Contractionary Monetary Policy - how it works:
CB sells bonds
to public and
banks
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checkable
deposits and
bank reserves
Excess
reserves,
money
supply
FF Rate
Interest
rates
C, I
AD
GDP,
employment,
price level
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy - OMO (AP only)
Quick Quiz:
For each of the following, draw an AD/AS diagram showing the effect on
America's national output, price level and employment. Then identify an open
market operation the Federal Reserve Bank can engage in to try and correct
each of the problems described.
•
•
•
•
•
Falling incomes in Canada lead to a decline in exports from US
Housing bubble causes rapid and frightening increase in real estate prices
Supply shock caused by sudden increase in oil prices
Low consumer confidence leads to 30% decrease in retail sales
Strong dollar leads to large increase in imports
Use the following diagrams to illustrate the effect of the Fed's open market
operations.
• Bond market
• Money market
• AD/AS diagram
Practice with Monetary Policy: NCEE Workbook Units
38, 39 and 40
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy - Reserve Ratio (AP Only)
The Reserve Ratio (AP only): another “tool” a Central Bank can use to influence the
money supply
• It is the fraction of total deposits that banks are required to keep on reserve.
• In the Unites States commercial banks deposit their required reserves to their
regional Federal Reserve Bank. Commercial banks only keep a tiny fraction of their
total required reserves in their own vaults on any given day
Excess reserves: The amount of a bank's reserves beyond those required by the
government or central bank. Excess reserves may be lent out to earn interest for the
bank
Raising the reserve ratio increases required reserves and shrinks excess reserves.
Any loss of excess reserves shrinks banks’ lending ability and, therefore, the
potential money supply by a multiple amount of the change in excess reserves.
Lowering the reserve ratio decreases the required reserves and expands excess
reserves. Gain in excess reserves increases banks’ lending ability and, therefore, the
potential money supply by a multiple amount of the increase in excess reserves.
Changing the reserve ratio has two effects.
• It affects the size of excess reserves (the amount of total deposits a bank is
allowed to lend to borrowers to finance investment and consumption)
• It changes the size of the monetary multiplier (which determines how much
the total money supply will increase after a change in monetary policy by the
Central Bank)
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26
IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy - Reserve Ratio (AP Only)
The Money Multiplier: The money multiplier tells us the maximum amount of new
money that can be created by a single initial dollar of excess reserves. This
multiplier, m, is the inverse of the reserve requirement, R: m = 1/R
The US Federal Reserve Bank requires commercial banks to keep 10% of their total
deposits in reserve.
RR = .1 >>> Money Multipler (m) = 1/.1 = 10
ΔMoney Supply = Initial change in deposits x m
Example: Assume the Fed buys bonds from the public totaling $10b. Since money in the
Central Bank is not part of the money supply, the total change in deposits in US banks will
equal $10b. Banks are allowed to lend out everything beyond 10% of that. SO...
ΔMoney Supply = $10b x 10 = $100b
If the change in bank deposits is from money already in the money supply (i.e. a
worker deposits a paycheck or you deposit a birthday check from your grandparents),
then we must subtract the original amount from total change in the money supply
Example: Jonny deposits a $1000 check from his grandpa in the bank. How
much new money is created because of his wise decision to save his money?
ΔMoney Supply = ($1000 x 10) - $1000 = $9000
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IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy - Reserve Ratio (AP Only)
The Reserve Ratio as a tool of Monetary Policy: Changing the reserve ratio
is a powerful way to stimulate or reduce total spending in the economy
For example: Assume the US Fed wishes to restrict the total amount of money in
circulation to increase the interest rate and reduce C and I. By raising the reserve
ratio, it can achieve a smaller money supply and a higher interest rate.
Before:
Fed Action:
After:
RR = .10
m = 1/.10 = 10
Fed raises RR to .15
RR = .15
m = 1/.15 = 6.67
• A customer deposits $100:
• Before: Bank keeps $10 in reserve, loans out $90 >>> 90 x 10 = $900 new
money created!
• After: Bank keeps $15 in reserve, loans out $85 >>> 85 x 6.67 = only
$566.95 new money created!
With fewer excess reserves to lend out, the supply of loanable funds decreases and the
interest rate rises. When new deposits are made, the banks must keep a larger
proportion in reserve, reducing the overall money supply in the economy
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28
IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy - Discount Rate (AP Only)
The Discount Rate - the third Monetary Policy available to a Central Bank:
The discount rate is the interest rate that the Central Bank charges to commercial
banks that borrow from the Central Bank
• The Central Bank (the Fed in the US) is "lender of last resort" to commercial banks
that have immediate needs for additional funds (i.e. if at the end of a business day a
bank does not have enough in its reserves to meet its reserve requirements, it must
borrow from other banks or from the Fed to fulfill this reserve requirement)
• Commercial banks can temporarily increase their reserves by borrowing from the
Fed.
• An increase in the discount rate signals that borrowing reserves is more difficult
and will tend to shrink excess reserves.
• A decrease in the discount rate signals that borrowing reserves will be easier and
will tend to expand excess reserves.
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29
IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Monetary Policy (AP Only)
Three Monetary Policy tools: Relative importance
OMO - Open-market operations is the buying and selling of government bonds in the
financial market. Because it is the most flexible, bond holdings by the central bank can be
adjusted daily, and have an immediate impact on banks' reserves and the supply of money
in the economy
Reserve ratio: The RR is RARELY changed. RR in the US has been .10 since 1992. Reserves
held by the Central Bank earn no interest, so if RR is raised, banks' profits suffer
dramatically since they have to deposit more of their total reserves with the Fed where
they earn no interest. Banks prefer to be able to lend out as much of their total reserves
as possible
Discount rate: Until recently, the discount rate in the US was rarely adjusted on its own,
and instead hovered slightly above the federal funds rate*. In 2008, the US Fed lowered
the discount rate to very low levels as uncertainty among commercial banks brought
private lending to a halt. The "discount window" is only supposed to be used in the case of
private lenders being unable to acquire funds, hence the Fed is the lender of last resort
Discount rate called into action - March 17, 2008...
"The Federal Reserve announced a series of steps Mar. 16 to help provide relief to a
spreading credit crisis that threatens to plunge the economy into recession: The central
bank approved a cut to its lending rate to financial institutions, from 3.5% to 3.25%, and
created another lending facility for big investment banks to secure short-term loans."
*Federal Funds Rate: The interest rate that banks charge one another on
overnight loans made from temporary excess reserves.
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30
IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Evaluating Fiscal and Monetary Policies
Crowding-out effect: when a deficit-financed increase in government spending
drives up interest rates, thereby directing productive resources away from the
private sector towards the public sector
Question: How do governments get money to finance their budgets if they lower
taxes at the same time that they increase spending (expansionary fiscal policy)?
Answer: they borrow from the public by issuing new government bonds
BOND (definition): The general term for a long-term loan in which a borrower agrees to pay
a lender an interest rate (usually fixed) over the length of the loan and then repay the
principal at the date of maturity. Bond maturities are usually 10 years or more, with 30 years
quite common. Bonds are used by corporations and federal, state, and local governments to
raise funds. (source: www.amosweb.com/)
What causes crowding out?
• When the government issues new bonds to finance its budget deficits, the supply of bonds
increases in the bond market, lowering the bond price and increasing the interest rates on
bonds
• The higher return on government bonds directs savings away from commercial banks,
decreasing the supply of loanable funds to for the private sector to invest with, driving up
commercial interest rates
• The increase in borrowing by the government may lead to a decline in private investment,
thus "crowding-out" private enterprise in the economy
• Crowding-out can also refer to the re-allocation of physical resources (labor, land and
capital) away from the private sector towards the public sector as the government embarks
on projects requiring large inputs of productive resources.
www.welkerswikinomics.com
31
IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Evaluating Fiscal and Monetary Policies
Crowding-out effect: Graphical representation
Two ways to illustrate crowding-out:
• The impact on the Money Market
• The impact on the Loanable Funds Market (AP only)
Crowding-out in the Money Market (IB and AP)
Money Market
S1
Interest rate
Interest rate
S
Investment Demand
7%
5%
D2
Dmoney
Q1
Quantity of money
www.welkerswikinomics.com
Private investment is
"crowded-out" due to
increased government
borrowing
Q2
Interpretation: The
government's "transaction
demand" for money
increases as it must finance
its budget deficit, shifting
money demand out, driving
up interest rates
DI
Q1
Quantity of Investment
32
IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Evaluating Fiscal and Monetary Policies
Crowding-out effect: Graphical representation
The Loanable Funds Market (AP only): the loanable funds market is a hypothetical
market that brings savers and borrowers together, also bringing together the money available in
commercial banks and lending institutions available for firms and households to finance
expenditures, either investments or consumption (source: Wikipedia)
• Savers supply the loanable funds; for instance
• In return, borrowers demand loanable funds
Interest Rate
Loanable Funds
SLF
SLF: There is a direct relationship between
the interest rate and the supply of loanable
funds because at higher interest rates,
savers want their money in banks and other
institutions to earn the generous return
DLF: There is an inverse relationship between
the interest rate and the demand for
loanable funds because at lower interest
rates households and firms want to take
money out of savings to consume and invest
ire
DLF
Qe
Blog PostQuantity
- "Loanable
Funds
vs. Money Market: what’s the difference?"
of Loanable
Funds
www.welkerswikinomics.com
33
IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Evaluating Fiscal and Monetary Policies
Crowding-out effect: Graphical representation
Crowding out in the Loanable Funds Market (AP only):
• Public borrowing directs funds away from the private market for loanable funds as investors are
attracted to the higher interest rates on government bonds. The supply of loanable funds in the
private sector decreases
• Fewer funds available in commercial banks drive the interest rate up, which decreases the level of
private investment
SLF
Investment Demand
Interest rate
Interest Rate
Loanable Funds
S1
6%
5%
DLF
Qe Qe
Quantity of Loanable Funds
Private investment is
"crowded-out" due to
increased government
borrowing
DI
Q2 Q1
Quantity of Investment
Blog posts: "the Crowding-out effect"
www.welkerswikinomics.com
34
IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Evaluating Fiscal and Monetary Policies
ThinkEconomics ~ Economic Policy Tools
Follow the link above for a great practice activity with fiscal and monetary
policies and their effect on AD/AS. The following is from the ThinkEconomics site:
To achieve the economic goals of low unemployment and stable prices, the Congress and the
President can use two fiscal policy instruments, government spending and taxation to affect
real GDP and the price level. In addition, the Federal Reserve can use three monetary policy
instruments, open market operations and changes in the discount rate and required reserve
ratio to change real GDP and the price level.
An increase in government spending G or a decrease in autonomous taxes, ceteris paribus,
increase aggregate demand, thereby increasing both the equilibrium level of real GDP, Q*, and
the equilibrium price level P*. Alternatively, a decrease in government spending G or an
increase in autonomous taxes, ceteris paribus, decrease aggregate demand, thereby
decreasing both the equilibrium level of real GDP, Q*, and the equilibrium price level P*.
A Federal Reserve (Fed) open market purchase of U.S. securities, a decrease in the discount
rate or a decrease in the required reserve ratio increase the money supply, thereby increasing
aggregate demand and the equilibrium level of real GDP, Q*, and the equilibrium price level,
P*. Alternatively, a Fed open market sale of U.S. securities, an increase in the discount rate or
an increase in the required reserve ratio decrease the money supply, thereby decreasing
aggregate demand and the equilibrium level of real GDP, Q*, and the equilibrium price level,
P*.
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35
IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Practice Problems
Illustrating the macroeconomy
Analyse the impact of the following scenarios on the US economy. Remember ­ the scenarios could impact either AS or AD, or both! It is often easier, initially, to analyse the effect on just one area ­ just make it clear why you have chosen to use AS or AD. In some cases, the scenario could affect more than one variable. Think carefully about how you would analyze such cases.
• Government announces a large increase in spending on health and education. Impact on AD
Impact on AS
• Washington announces tax exemption scheme on new investments for small to medium sized businesses. Impact on AD
Impact on AS
• Average wage rises way above inflation for the third month running. Impact on AD
Impact on AS
• Exchange rate appreciation knocks export hopes for manufacturing. Impact on AD
Impact on AS
• Share prices tumble, wiping 20% off company values. Impact on AD
Impact on AS
• Surveys show clear signs of optimism for the future of the economy. Impact on AD
Impact on AS
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36
IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Practice Problems
• American productivity levels at their highest level for 10 years. Impact on AD
Impact on AS
• Government 'stealth taxes' increase tax burden to highest level for 50 years. Impact on AD
Impact on AS
• Expansion in numbers of students attending higher education exceeds government targets. Impact on AD
Impact on AS
• Federal Reserve signals rise in interest rates of ½%. Impact on AD
Impact on AS
• No rate rise in US but UK and EU central banks increase interest rates. Impact on AD
Impact on AS
• Radical reform of welfare spending should help government cut spending as a proportion of GDP. Impact on AD
Impact on AS
• Stability of inflation cheers business leaders. Impact on AD
Impact on AS
• United States leads the way in nano­technology development Impact on AD
Impact on AS
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37
IB /AP Economics Unit 3.4 Demand­side and Supply­side Policies
Demand and Supply-Side Policies
Classical vs. Keynesian
Classical vs. Keynesian policies: Classical economists are sometimes
referred to as "supply-siders", Keynesians as "demand-siders" Why is this?
PL
LRAS
Talk to a Classical economist, and they will advise
SRAS
‘Don’t just do something, sit there!’
Pe
while a Keynesian will advise,
'Don't just sit there, do something!"
AD
With partners, discuss and illustrate the various policy
responses to the following macroeconomic problems.
real GDP
Yfe
Group A:
• Problem: sharp rise in oil prices
• Keynesian response
• Classical response
Group C:
• Problem: Increased demand from abroad for
exports fuels domestic inflation
• Keynesian response
• Classical response
Group B:
• Problem: Stock market bubble bursts
• Keynesian response
• Classical response
Group D:
• Proble: Embargo placed on country's exports
• Keynesian response
• Classical response
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