Week_10 - ECMA06 Stabilization Policy The Introduction of...

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Outline Discuss the effectiveness of monetary policy in affecting output. Use of fiscal & monetary policies to smooth out business cycles. Discuss issues related to stabilization policy such as the crowding out effect and national debt. Introduce open economy in our model – discuss the country’s balance of payments. Does Monetary Policy Always Work? Monetary policy could be used to affect output: To increase output the central bank should run expansionary monetary policy. To decrease output the central bank should run contractionary monetary policy. 1
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Question: Does monetary policy always work (i.e., could it be used to affect output)? Answer: Yes if the links hold up. For example, when MS , interest rate . This in interest rate would stimulate (physical) investment if firms and households were willing to invest. Investment AE AD Y . However, if the economy is a severe recession, the above process could fail and the economy may in a liquidity trap. A liquidity trap is situation in which the interest rate is extremely low (close to zero) such that monetary policy is no longer effective (i.e., could not be used to affect output). Question: Do we witness any liquidity trap? Answer: Yes, it could happen during major recessions. Examples include the U.S. in the 1930s, Japan in the 1990s. The U.S. in the present? Would Canada have one in the near future? 2
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Let’s take a look at how this works. r MS 0 r r 0 MD I(r) M I I 0 Recall, the link between MS and AD is indirect. It works through the change in interest rate and then the change in investment. However, if the interest rate is already close to zero, then a change in MS will have no effect on interest rate. Why? Nominal interest rate CANNOT be negative! 3
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Comparison Between Monetary Policy and Fiscal Policy – How Fiscal and Monetary Policies Affect Aggregate Demand Fiscal policy – the government’s choice regarding levels of spending, taxes, and transfers. Monetary policy – the central bank’s choice regarding money supply. Both fiscal and monetary policies are, sometimes, referred as stabilization policy – public policy aimed at reducing the fluctuations in output in the short run. Expansionary Fiscal Policy This includes G , T , or TR . An
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This note was uploaded on 06/18/2011 for the course ECMA 06 taught by Professor Dr.atamazaheri during the Spring '10 term at University of Toronto.

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Week_10 - ECMA06 Stabilization Policy The Introduction of...

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