ECON 1110 Lecture Notes 06

ECON 1110 Lecture Notes 06 - ECON 1110 Lecture Notes 6 ECON...

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ECON 1110 Intermediate Macroeconomics James R. Maloy Spring 2011 Lecture Notes for Topic 6: Keynesian Macroeconomics (III) Readings: Froyen Ch. 7 (8 th Ed. Ch. 8) In this section, we will discuss the role of demand management in the Keynesian system, i.e. the use of fiscal/monetary policies to adjust aggregate demand and output. The overall goal of such policies in the Keynesian system is to stabilise output, employment and prices—i.e. keep AD stable—by counterbalancing any AD shifts (due primarily to volatile investment), thus eradicating the business cycle. I. Monetary Policy in the IS-LM Model In the last topic we discussed factors that cause a shift in the LM curve—changes in money supply or money demand. Monetary policy is the manipulation of the money supply to change equilibrium income. Suppose the central bank wants to increase equilibrium income. They will increase the money supply (the methods and tools of the central bank will be discussed in the spring term), thus shifting the LM curve to the right. At the new equilibrium, output has increased and the interest rate has fallen. How does monetary policy work? Why does increasing the money supply increase output? There is some disagreement about how monetary policy actually works. In the Keynesian system, monetary policy works through what is known as the indirect transmission process. In economic terms, the increase in the money supply creates an excess supply of money at the current interest rate, which causes the interest rate to fall. (Remember the money market analysis from the last chapter.) As the interest rate falls, investment will increase, and thus income will rise. The rise in income will boost consumption through the multiplier effect. Both of these factors will then boost the quantity of money demanded, since money demand is a positive function of income. At the new equilibrium, income is higher and interest rates are lower. This is where the new LM curve intersects the IS curve. Hence the indirect transmission process—changes in money yield changes in interest rates, which in turn cause changes in consumption, investment, and output. Monetary policy works indirectly via the interest rate. A monetary contraction is a decrease in the money supply, and has the opposite
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ECON 1110 Lecture Notes 06 - ECON 1110 Lecture Notes 6 ECON...

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