Week_10_-_Stabilization_Policy

Week_10_-_Stabilization_Policy - 1 ECMA06 Stabilization...

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1 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.
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2 Effectiveness of Monetary Policy Monetary policy could be used to affect output. To increase output the central bank should run expansionary monetary policy: MS r I AE & AD Y . To decrease output the central bank should run contractionary monetary policy. MS r I AE & AD Y . The above processes work because we assume both firms and households are willing to adjust their investment plans when interest rate changes. However, if the economy is in a severe recession, the above process could fail (i.e., firms and households may NOT respond to a change in interest rate) – 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).
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3 r MS 0 r r 0 MD I(r) M I I 0 Recall, MS affects AD through changes in r and I. If the interest rate is already close to zero, then a change in MS will have no effect on interest rate. Nominal interest rate CANNOT be negative! Question: Do we witness any liquidity trap? Answer: Yes, examples include the U.S. in the 1930s, Japan in the 1990s. The U.S. in the present?
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4 Comparing 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 the level of 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 (i.e., keeping Y close to Y FE ). How Expansionary Fiscal Policy Affects Output Expansionary fiscal policy includes G , T , and/or TR . An in G simulates AD directly since G enters the AE and AD functions directly. A in T or an in TR affects AD indirectly . A in T or an in TR increases DI. DI C AE and AD Y .
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5 How Expansionary Monetary Policy Affects Output When the central bank conducts open market purchase, MS r I AE and AD Y . The effectiveness of this open market purchase depends on:
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This note was uploaded on 12/21/2011 for the course ECONOMICS ECMA06 taught by Professor Dr.atamazaheri during the Spring '10 term at University of Toronto.

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Week_10_-_Stabilization_Policy - 1 ECMA06 Stabilization...

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