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Chapter15
Chapter15
TheInfluenceofMonetaryand
FiscalPolicyonAggregate
Demand
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Inthischapter,
lookfortheanswerstothesequestions:
How does the interest-rate effect help explain the
slope of the aggregate-demand curve?
How can the central bank use monetary policy to
shift the AD curve?
In what two ways does fiscal policy affect
aggregate demand?
What are the arguments for and against
using policy to try to stabilize the economy?
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Introduction
Earlier chapters covered:
the long-run effects of fiscal policy
on interest rates, investment, economic growth
the long-run effects of monetary policy
on the price level and inflation rate
This chapter focuses on the short-run effects
of fiscal and monetary policy,
which work through aggregate demand.
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AggregateDemand
Recall, the AD curve slopes downward for three
reasons:
The wealth effect
The interest-rate effect
The exchange-rate effect
the most important
of these effects for
the economy
Next:
We will study a model that helps explain the
interest-rate effect and how monetary policy
affects aggregate demand.
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TheTheoryofLiquidityPreference
A simple theory of the interest rate (denoted r)
r adjusts to balance supply and demand
for money
Money supply: assume fixed by central bank,
does not depend on interest rate
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TheTheoryofLiquidityPreference
Money demand reflects how much wealth
people want to hold in liquid form.
For simplicity, suppose household wealth
includes only two assets:
Money liquid but pays no interest
Bonds pay interest but not as liquid
A households money demand reflects its
preference for liquidity.
The variables that influence money demand:
Y, r, and P.
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MoneyDemand
Suppose real income (Y) rises. Other things equal,
what happens to money demand?
If Y rises:
Households want to buy more g&s,
so they need more money.
To get this money, they attempt to sell some of
their bonds.
I.e., an increase in Y causes
an increase in money demand, other things equal.
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ACTIVELEARNING1
Thedeterminantsofmoneydemand
A. Suppose r rises. Other things equal, what
happens to money demand?
B. Suppose P rises. Other things equal, what
happens to money demand?
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ACTIVELEARNING1
Answers
A. Suppose r rises. Other things equal, what
happens to money demand?
r is the opportunity cost of holding money.
An increase in r reduces money demand:
households attempt to buy bonds to take
advantage of the higher interest rate.
Hence, an increase in r causes a decrease in
money demand, other things equal.
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ACTIVELEARNING1
Answers
B. Suppose P rises. Other things equal, what
happens to money demand?
If Y is unchanged, people will want to buy the
same amount of g&s.
Since P is higher, they will need more money to
do so.
Hence, an increase in P causes an increase in
money demand, other things equal.
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HowrIsDetermined
Interest
rate
MS curve is vertical:
Changes in r do not
affect MS, which is
fixed by the BoC.
MS
r1
Eqm
interest
rate
MD1
MD curve is
downward sloping:
A fall in r increases
money demand.
M
Quantity fixed
by the BoC
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HowtheInterestRateEffectWorks
A fall in P reduces money demand, which lowers r.
Interest
rate
P
MS
r1
r2
P1
MD1
P2
AD
MD2
M
Y1
Y2
Y
A fall in r increases I and the quantity of g&s demanded.
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MonetaryPolicyandAggregateDemand
To achieve macroeconomic goals, the BoC can
use monetary policy to shift the AD curve.
The BoC can change the money supply by
buying and selling government bonds by
conducting open market operations.
This changes the interest rate and shifts the AD
curve.
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TheEffectsofReducingtheMoney
Supply:ClosedEconomy
The BOC can raise r by reducing the money supply.
Interest
P
MS2 MS1
rate
r2
P1
r3
r1
MDMD1
2
M
AD1
AD2
Y2
Y1
Y
An increase A educes the quantity of for demanded.
The decrease in r rD reduces the demand g&smoney.
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ACTIVELEARNING2
Monetarypolicy
For each of the events below,
- determine the short-run effects on output
- determine how the BoC should adjust the money
supply and interest rates to stabilize output
A. The Minister of Finance tries to balance the budget by
cutting govt spending.
B. A stock market boom increases household wealth.
C. War breaks out in the Middle East,
causing oil prices to soar.
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ACTIVELEARNING2
Answers
A. The Minister of Finance tries to balance the
budget by cutting govt spending.
This event would reduce aggregate demand
and output.
To offset this event, the BoC should increase
MS and reduce r to increase aggregate
demand.
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ACTIVELEARNING2
Answers
B. A stock market boom increases household
wealth.
This event would increase aggregate demand,
raising output above its natural rate.
To offset this event, the BoC should reduce MS
and increase r to reduce aggregate demand.
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ACTIVELEARNING2
Answers
C. War breaks out in the Middle East,
causing oil prices to soar.
This event would reduce aggregate supply,
causing output to fall.
To offset this event, the BoC should increase
MS and reduce r to increase agg demand.
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OpenEconomyConsiderations
A monetary injection by the Bank of Canada
causes the dollar to depreciate in value;
the dollar depreciation causes net exports to
rise;
there is an additional increase in demand for
Canadian-produced goods and services not
realized in a closed economy; and
in the end, a monetary injection in an open
economy shifts the aggregate-demand curve
farther to the right than in a closed economy.
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OpenEconomyConsiderations
The Bank of Canada cannot simultaneously
choose the size of the money supply and the
value of the Canadian dollar.
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AMonetaryInjectioninanOpen
Economy
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AMonetaryInjectioninanOpen
Economy
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FiscalPolicyandAggregateDemand
Fiscal policy: the setting of the level of govt
spending and taxation by govt policymakers
Expansionary fiscal policy
an increase in G and/or decrease in T
shifts AD right
Contractionary fiscal policy
a decrease in G and/or increase in T
shifts AD left
Fiscal policy has two effects on AD...
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1.TheMultiplierEffect
If the govt buys $20b of planes from Boeing,
Boeings revenue increases by $20b.
This is distributed to Boeings workers (as wages)
and owners (as profits or stock dividends).
These people are also consumers and will spend
a portion of the extra income.
This extra consumption causes further increases
in aggregate demand.
Multiplier effect:: the additional shifts in AD
Multiplier effect the additional shifts in AD
tthat result when fiscal policy increases income
hat result when fiscal policy increases income
and thereby increases consumer spending
and thereby increases consumer spending
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1.TheMultiplierEffect
A $20b increase in
G initially shifts AD
to the right by $20b.
P
AD1
The increase in Y
causes C to rise,
which shifts AD
further to the right.
AD3
AD2
P1
$20 billion
Y1
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Y2
Y3
Y
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MarginalPropensitytoConsume
How big is the multiplier effect?
It depends on how much consumers respond to
increases in income.
Marginal propensity to consume (MPC):
the fraction of extra income that households
consume rather than save
E.g., if MPC = 0.8 and income rises $100,
C rises $80.
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AFormulafortheMultiplier
Notation: G is the change in G,
Y and C are the ultimate changes in Y and C
Y = C + I + G + NX
identity
Y = C + G
I and NX do not change
Y = MPC Y + G
because C = MPC Y
1
Y =
G
1 MPC
solved for Y
The multiplier
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AFormulafortheMultiplier
The size of the multiplier depends on MPC.
E.g.,
if MPC = 0.5
if MPC = 0.75
if MPC = 0.9
1
Y =
G
1 MPC
The multiplier
multiplier = 2
multiplier = 4
multiplier = 10
A bigger MPC means
A bigger MPC means
changes in Y cause
changes in Y cause
bigger changes in C,,
bigger changes in C
which in turn cause
which in turn cause
more changes in Y..
more changes in Y
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OtherApplicationsoftheMultiplierEffect
The multiplier effect:
Each $1 increase in G can generate
more than a $1 increase in agg demand.
Also true for the other components of GDP.
Example: Suppose a recession overseas
reduces demand for Canadian net exports by
$10b.
Initially, agg demand falls by $10b.
The fall in Y causes C to fall, which further
reduces agg demand and income.
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2.TheCrowdingOutEffect
Fiscal policy has another effect on AD
that works in the opposite direction.
A fiscal expansion raises r,
which reduces investment,
which reduces the net increase in agg demand.
So, the size of the AD shift may be smaller than
the initial fiscal expansion.
This is called the crowding-out effect.
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HowtheCrowdingOutEffectWorks
A $20b increase in G initially shifts AD right by $20b
Interest
rate
P
MS
AD3 AD2
AD1
r2
r1
P1
$20 billion
MD2
MD1
M
Y1
Y3
Y2
Y
But higher Y increases and MD r, which reduces AD.
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OpenEconomyConsiderations
Canadas interest rate must equal the world
interest rate
The interest rate increased as a result of the
increased government spending
Higher interest rate increases demand for
Canadian assets and therefore the Canadian
dollar
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OpenEconomyConsiderations:Flexible
ExchangeRates
If the Bank of Canada allows the exchange rate
to be flexible, the dollar appreciates, which
makes Canadian-produced goods and services
relatively more expensive, and Canadas net
exports fall.
This is an additional crowding-out effect (on net
exports) that reduces the demand for Canadianproduced goods and services.
In the end, fiscal policy has no lasting effect on
aggregate demand.
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FiscalExpansioninanOpenEconomy
withaFlexibleExchangeRate
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FiscalExpansioninanOpenEconomy
withaFlexibleExchangeRate
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OpenEconomyConsiderations:Fixed
ExchangeRates
To prevent the appreciation of the dollar,
the BoC increases the money supply by
selling dollars in the market for foreigncurrency exchange;
this increase in the money supply also
prevents the interest rate from changing
As a result, both forms of crowding out are
avoided
In the end, the fiscal expansion has a large
effect on aggregate demand.
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FiscalExpansioninanOpenEconomy
withaFlexibleExchangeRate
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FiscalExpansioninanOpenEconomy
withaFlexibleExchangeRate
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ChangesinTaxes
A tax cut increases households take-home pay.
Households respond by spending a portion of this
extra income, shifting AD to the right.
The size of the shift is affected by the multiplier
and crowding-out effects.
The change in the position of the AD curve will
depend on the BoCs decision to let the exchange
rate to change.
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ACTIVELEARNING3
Exercise
The economy is in recession.
Shifting the AD curve rightward by $20b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
B. If there is crowding out, will the govt need to
increase G more or less than this amount?
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ACTIVELEARNING3
Answers
The economy is in recession.
Shifting the AD curve rightward by $20b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should the govt increase G
to end the recession?
Multiplier = 1/(1 .8) = 5
Increase G by $4b
to shift agg demand by 5 x $4b = $20b.
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ACTIVELEARNING3
Answers
The economy is in recession.
Shifting the AD curve rightward by $20b
would end the recession.
B. If there is crowding out, will the govt need to
increase G more or less than this amount?
Crowding out reduces the impact of G on AD.
To offset this, the govt should increase G by a
larger amount.
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DeficitReduction
Deficit reduction can be accomplished with
reduced government spending, increased taxes,
or a combination of the two
Deficit reduction can have a minimal impact on
the level of aggregate demand if the central
bank adopts the appropriate exchange-rate
policy
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FYI:FiscalPolicyandAggregateSupply
Most economists believe the short-run effects of
fiscal policy mainly work through agg demand.
But fiscal policy might also affect agg supply.
Recall one of the Ten Principles from Chap 1:
People respond to incentives.
A cut in the tax rate gives workers incentive to
work more, so it might increase the quantity of
g&s supplied and shift AS to the right.
People who believe this effect is large are called
Supply-siders.
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FYI:FiscalPolicyandAggregateSupply
Govt purchases might affect agg supply.
Example:
Govt increases spending on roads.
Better roads may increase business productivity,
which increases the quantity of g&s supplied,
shifts AS to the right.
This effect is probably more relevant in the long
run: it takes time to build the new roads and put
them into use.
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UsingPolicytoStabilizetheEconomy
Economists debate how active a role the govt
should take to stabilize the economy.
Automatic stabilizers are changes in fiscal policy
that stimulate aggregate demand when the
economy goes into a recession without
policymakers having to take any deliberate
action.
Automatic stabilizers include the tax system and
some forms of government spending.
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TheCaseforActiveStabilizationPolicy
Keynes: Animal spirits cause waves of
pessimism and optimism among households and
firms, leading to shifts in aggregate demand and
fluctuations in output and employment.
Also, other factors cause fluctuations, e.g.,
booms and recessions abroad
stock market booms and crashes
If policymakers do nothing, these fluctuations are
destabilizing to businesses, workers, consumers.
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TheCaseforActiveStabilizationPolicy
Proponents of active stabilization policy
believe the govt should use policy
to reduce these fluctuations:
When GDP falls below its natural rate,
use expansionary monetary or fiscal policy
to prevent or reduce a recession.
When GDP rises above its natural rate,
use contractionary policy to prevent or reduce
an inflationary boom.
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SomeProKeynesians:2009
Stephen Harper and the stimulus package.
Barack Obama pushed for spending increases
and tax cuts to increase aggregate demand in the
face of a deep recession.
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TheCaseAgainstActiveStabilizationPolicy
Monetary policy affects economy with a long lag:
Firms make investment plans in advance,
so I takes time to respond to changes in r.
Most economists believe it takes at least
6 months for mon policy to affect output and
employment.
Fiscal policy also works with a long lag:
Changes in G and T require a legislative
process, which can take months or years.
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TheCaseAgainstActiveStabilizationPolicy
Due to these long lags, critics of active policy
argue that such policies may destabilize the
economy rather than help it:
By the time the policies affect agg demand,
the economys condition may have changed.
These critics contend that policymakers should
focus on long-run goals like economic growth
and low inflation.
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AutomaticStabilizers
Automatic stabilizers:
changes in fiscal policy that stimulate
agg demand when economy goes into recession,
without policymakers having to take any
deliberate action
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AFlexibleExchangeRateasan
AutomaticStabilizer
A U.S. recession would cause Canadian net
exports to fall, lowering aggregate demand
However, with flexible exchange rates
Lower Canadian income 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
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AutomaticStabilizers:Examples
The tax system
In recession, taxes fall automatically,
which stimulates agg demand.
Govt spending
In recession, more people apply for public
assistance (welfare, employment insurance).
Govt spending on these programs automatically
rises, which stimulates agg demand.
The fiscal stimulus package of 2008-2009
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CONCLUSION
Policymakers need to consider all the effects of
their actions. For example,
When the govt cuts taxes, it should consider the
short-run effects on agg demand and
employment, and the long-run effects
on saving and growth.
When the BoC reduces the rate of money
growth, it must take into account not only the
long-run effects on inflation but the short-run
effects on output and employment.
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CHAPTERSUMMARY
In the theory of liquidity preference,
the interest rate adjusts to balance
the demand for money with the supply of money.
The interest-rate effect helps explain why the
aggregate-demand curve slopes downward:
an increase in the price level raises money
demand, which raises the interest rate, which
reduces investment, which reduces the
aggregate quantity of goods & services
demanded.
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CHAPTERSUMMARY
An increase in the money supply causes the
interest rate to fall, which stimulates investment
and shifts the aggregate demand curve
rightward.
Expansionary fiscal policy a spending increase
or tax cut shifts aggregate demand to the right.
Contractionary fiscal policy shifts aggregate
demand to the left.
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CHAPTERSUMMARY
When the government alters spending or taxes,
the resulting shift in aggregate demand can be
larger or smaller than the fiscal change:
The multiplier effect tends to amplify the effects
of fiscal policy on aggregate demand.
The crowding-out effect tends to dampen the
effects of fiscal policy on aggregate demand.
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CHAPTERSUMMARY
Economists disagree about how actively
policymakers should try to stabilize the economy.
Some argue that the government should use
fiscal and monetary policy to combat
destabilizing fluctuations in output and
employment.
Others argue that policy will end up destabilizing
the economy because policies work with long
lags.
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