macro lecture ch16 fiscal and monetary policy

8/9/2019 Macro Lecture ch16 Fiscal and Monetary Policy

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Fiscal and Monetary Policy

Dr. Katherine Sauer

Principles of Macroeconomics

ECO 2010

1



Overview:

I. Monetary Policy and Aggregate DemandII. Fiscal Policy and Aggregate Demand

III. Should Policymakers use policy to stabilize the economy?

2



There are 2 broad types of policies that can be aimed at

influencing Aggregate Demand in the short run:

Monetary Policy (the Fed¶s decisions about the moneysupply and interest rates)

Fiscal Policy (Congress taxing and spending)

There are no polices that can effectively be aimed at influencing

Aggregate Supply in the short run.

Recall: AS will shift when there is a change in

land/natural resources

labor capital

technology

expected price level

3



4

I. Monetary Policy and Aggregate Demand

In the US economy, the interest rate effect is the main reason thatAggregate Demand slopes downward.

A. The Theory of Liquidity Preference is Keyne¶s theory that the

interest rate adjusts to bring money demand and money supply into

equality.

The Classical Theory says that

- the interest rate is what adjusts to balance the

supply and demand for loanable funds.

- the price level is what adjusts to balance the

money supply and money demand.



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The Classical Theory is relevant for the long run.

Keynes¶Theory of Liquidity Preference is relevant for the short run.

Keynes¶ version of the money market:

The money supply is M1 or M2.

- set and controlled by the Fed

The money demand is the amount of money needed for

transactions.

- determined by people¶s preference for liquidity

- As the interest rate rises, the opportunity cost of holding money in checking accounts or spending

money rises. (could be earning interest)

- So, people make fewer transactions and put more

money in savings.



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Thus, the quantity of money is inversely related to the interest rate.

- higher interest rate, save more, fewer transactions, lower

quantity of money demanded

- lower interest rate, save less, more transactions, higher

quantity of money demanded.



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r

Quantity of Money

MS

The Money Supply is

vertical because it is set by

the Fed.

It will shift when the Fed

changes monetary policy.

The Money Demand isdownward sloping.

- quantity of money is

inversely related to the

interest rate

It will shift if the price

level changes.

MD



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r

Quantity of Money

MS

The interest rate will adjust

to bring MS and MD into

equality.

(if r > r*, surplus of

money, interest rate falls)

(if r < r*, shortage of money, interest rate rises)

MD

r*



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B. Relationship between the Money Market and Aggregate Demand

QM

r

Y

P

P1

Y1

ADMD

MS

r1

Q1

1) Suppose the price level rises

2) The quantity of money people need for transactions increases,

so the money demand curve shifts right.

P2

1)

MD2

2)



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B. Relationship between the Money Market and Aggregate Demand

QM

r

Y

P

P1

Y1

ADMD

MS

r1

Q1

3) The interest rate rises.

4) When the interest rate rises, the quantity of Investment falls,

causing the quantity of AD to fall, as well as the level of RGDP.

P2

1)

MD2

2)

r2

3)

Y2

4)



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C. Effects of Monetary Policy

Expansionary monetary policy is used to speed up economic growth.- Fed buys bonds

- Fed lowers federal funds rate target

- Fed lowers discount rate

- Fed lowers reserve requirement ratio

Contractionary monetary policy is used to slow down economic

growth to combat inflation.



Ex: Suppose that the economy is sluggish. To help the

economy to grow, the Fed could lower the federal funds target

(Fed buys bonds).

QM

r

Y

P

Y1

ADMD

MS

r1

Q1

P

MS2

r2

1) This action will increase the money supply.

2) The interest rate falls.

Q2





(Fed buys bonds).

QM

r

Y

P

Y1

ADMD

MS

r1

Q1

P

MS2

r2

3) When the interest rate falls but the price level is constant,

Investment will increase, and AD will shift right.

Q2

AD2





(Fed buys bonds).

QM

r

Y

P

Y1

ADMD

MS

r1

Q1

P

MS2

r2

The result is an increase in RGDP at a given price level.

Q2

AD2

Y2



Ex: Suppose that recent increases in AD have led to inflation.

To combat the inflation, the Fed raises the federal funds rate

target (Fed sells bonds).

QM

r

Y

P

Y1

ADMD

MS

r1

Q1

P1

MS2

r2

1) This action will decrease the money supply.

2) The interest rate rises.

Q2

AS






QM

r

Y

P

Y1

ADMD

MS

r1

Q1

P1

MS2

r2

3) When the interest rate rises, Investment will fall and AD will

shift left.

Q2

AS

AD2






QM

r

Y

P

Y1

ADMD

MS

r1

Q1

P1

MS2

r2

4) The price level falls (inflation falls), and real GDP falls.

Q2

AS

AD2

P2

Y2



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In common language,

increasing the money supplyand decreasing interest rates

are used interchangeably.



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II. Fiscal Policy and Aggregate Demand

Fiscal Policy refers to policymakers setting of the level of

government spending and taxing.

Expansionary Fiscal Policy:

tax cuts

increases in government spending

Contractionary Fiscal Policy:

tax increases

decreases in government spending (budget cuts)

A. A Change in Government Spending will have two effects:

1. multiplier effect

2. crowding out effect



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1. The Multiplier Effect is the additional shifts in AD that

result when expansionary fiscal policy increases income and

consumer spending.- each $1 the government spends will increase AD by

more than $1

Ex: Suppose the government buys $1billion worth of products.

- expect AD to increase by $1billion

- But, when the government buys things, money ends up

in the hands of firms and households.

- Because I and C increase, AD will increase by more

than $1billion.



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So, by how much will AD shift by ultimately?

We need to estimate how much of the additional income thehouseholds will spend versus save.

The Marginal Propensity to Consume (MPC) is the fraction of

extra income that households spend rather than save.

ex: If the MPC is 0.75, then a household receiving $100

in extra income would spend $75 of it.



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First round: the government spends $1billion

Second round: When this $1billion ends up as household

income, households will spend (0.75) of it:

(0.75)(1b) = $750million

Third round: When households spend the $750million, iteventually ends up as income for them again.

(0.75)(750m) = 562.5m

this is the same as (0.75)(0.75)(1b) = 562.5m

or (0.75)(1b)2



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So we have:

First Round: $1bSecond Round: + (0.75)($1b)

Third Round: + (0.75)($1b)

Fourth Round: + (0.75)($1b)

Fifth Round: +

etc«

($1b)( 1 + 0.75 + 0.75 + 0.75 + « )

This is an infinite geometric series and can be simplified into:

($1b) x 1 .

1 ± 0.75

2

2

3

3

= $4b



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The original $1b spending ultimately increases AD by $4b.

The term 1 . is known as the government multiplier .

1 - MPC

Ex: If the MPC is 0.60, then what is the value of the government

multiplier?

Ex: If the MPC is 0.60 and the government spends $20billion, by

how much will AD change?



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2. The Crowding Out Effect is the offset in AD that results when

expansionary fiscal policy raises the interest rate and decreases

investment spending.

When the government makes a purchase, money demand

increases because:

- transactions are being made.

- consumers and firms see an increase in the price level .

- gov¶t spending increases AD, when AD shifts

right the price level rises (AD/AS market)

As money demand increases, the interest rate rises, so

investment falls.

As investment falls, AD falls.



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The end result will depend on which effect is stronger:

If Multiplier Effect > Crowing Out Effect, then AD rises.

If Multiplier Effect < Crowing Out Effect, then AD falls.

(In reality, ME is usually > COE)



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B. Change in Taxes

(Tax policy may affect AS in the Long Run)

Changing taxes affects household disposable income.

Decreasing taxes is meant to increase AD by way of

Consumption.-whether the cut is permanent or temporary plays a role

Increasing taxes is often done to pay for government spending,

and has a negative affect on C and AD.



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A tax cut has the effect of giving households extra income.

The fraction of the extra income that they spend is the MPC.

Ex: Suppose Congress passes a $100m tax cut for families and

the MPC is 0.65.

Consumption will increase by ($100m)(0.65) = $65m

and so will Aggregate Demand.

**AD increases by less than the amount of the tax cut.**



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III. Should Policymakers use policy to stabilize the economy?

A. The Case For Active Stabilization Policy

Suppose that Congress raises taxes to pay for the deficit:

- taxes rise

- consumption falls- AD decreases

- the price level falls (deflation?)

- RGDP falls (unemployment rises)

The Fed may wish to intervene to prevent deflation and risingunemployment.

- increase money supply

- decrease interest rates

- stimulate AD



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Sometimes monetary policy can be used to counteract the effects

of fiscal policy.

The Employment Act of 1946:

Government gave itself the role of promoting full

employment.

1) Government should avoid being the cause of economicfluctuations.

2) Government should respond to changes in the private

economy in order to stabilize AD

(Keynes)



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B. The Case Against Using Policy to Stabilize the Economy

Policy is good to use for long run goals:- low inflation

- stable economic growth

Policy works with a lag and doesn¶t work for fine-tuning the

economy.- Monetary Policy lag is estimated to be 6 months

before it affects output and unemployment.

(firms plan in advance about investment decisions)

- Fiscal Policy has to go through the political process

before it gets implemented

By the time policy kicks in, the economy is different!



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C. Automatic Stabilizers

An economy can build in automatic stabilizers in lieu of using discretionary policy.

1. Tax System:

- in a recession, people pay less in taxes and retainmore of their income

- dampens the decrease in AD

- in expansion, people pay more in taxes and retain

less of their income- dampens the increase in AD



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2. Government Assistance Programs:

- in a recession, people utilize welfare and

unemployment more- government spending rises, incomes are

stabilized

- dampens the decrease in AD

- in expansions, people don¶t use welfare and

unemployment as much

- government spending falls

- dampens the increase in AD

macro lecture ch16 fiscal and monetary policy

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