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Cha34 The Influence of Monetaryand Fiscal Policy

on Aggregate Demand

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What we have learned in macroeconomics

Chap 25

Chap 26 Chap 27

Chap 28

Chap 29 Chap 30

The level and growth of productivity and real GDP

How the financial system works and How the real interest rate adjusts to balance saving and investment

Why there is always some unemployment in the economy

The monetary system and how changes inthe money supply affect the price level,the inflation rate, and the nominal interest rate

Chap 31 Chap 32

Extention of this analysis to open economies to explain the trade balance and the exchange rate.

GDP

Financial system

Unemployment

Monetary system

Open Economy

Chapter Key words Contens

Chap 33 .Discussing some of the important facts about short run fluctuations in economic activity and introducing a basic model to explain those fluctuations.

Aggregate demand and aggregate supply

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Index

1. How monetary policy influences aggregate demand

2. How fiscal policy influences aggregate demand

3. Using policy to stabilize the economy

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Index

1. How monetary policy influences aggregate demand

2. How fiscal policy influences aggregate demand

3. Using policy to stabilize the economy

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Why the aggregate-demand curve slopes down

quantity of output

Price level

•  The price level and consumption:The wealth effect –  Consumers are wealthier,which stimulates the demand for consumption goods.

•  The price level and investment:The interest rate effect –  Interest rates fall,the demand for investment goods.

•  The price level and net exports:The exchange rate effect –  The currency depreciates,which stimulates the demand for net exports.

Y=C+I+G+NX

The most important reasons for the demand slope of the aggregate demand curve

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The theory of liquidity preference

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Equilibrium in the money market

interest rate

Quantity of money

money supply

money demand

Money supply

Money demand

Equilibrium in the money market

・The Feds alters the money supply primarily by changing the quantity of reserves in the banking system through the purchase and sale of government bonds in open market operations.

・People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services. ・Interest rate is the opportunity costs of holding money.

・The interest rate adjusts to balance the supply and demand for money. ・There is one interst rate,called the equilibrium interest rate, at which the quantity of money demanded exactly balances the quantity of money supplied.

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1) A higher price level raises money demand. 2) Higher money demand leads to a higher interest rate. 3) A higher interest rate reduces the quantity of goods and serveices demanded.

The money market The Aggregate demadn curve interest rate

Quantity of money

Price Level

Quantity of Output

r2

r1

P2

P1

Money supply

money demand

aggregate demand

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Change in the money supply

When the Fed increases the money supply,it lowers the interest rate and increase the quantity of goods and services demanded for any given price level,shifting the aggregate demand curve to the right.

The money market The Aggregate demadn curve interest rate

Quantity of money

Price Level

Quantity of Output

r2

r1

P2

P1

Money supply

Money demand

aggregate demand

Y1 Y2

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The role of interest rate targets in Fed policy

•  Discussion of Fed policy often treat the interest rate,rather than the money supply,as the Fed's instrument.

•  There are several related reasons for the Fed's decisions to use the federal funds rate,rather than for the money supply.

–  The money supply is hard to measure with sufficient precision.

–  Money demand fluctuates over time.

–  For any given money supply,fluctuations in money demand would lead to fluctuations in interest rates,aggregate demand, and output.

•  The theory of liquidity preference illustrates an important principle: –  Monetary policy can be described either in terms of the money supply or in

termas of the interest rate.

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Index

1. How monetary policy influences aggregate demand

2. How fiscal policy influences aggregate demand

3. Using policy to stabilize the economy

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Shifting the aggregate demandindirectly and directly

Monetary Policy

Fiscal Policy

・Using interest controls,policy makers(The Fed) shift the aggregate demand curve indirectly by influencing the spending decisions of firms or house holds.

When government alters its own purchases of goods and services,it shifts the aggregate demand curve directly. -The multiplier effect -The crowding out effect

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The multiplier effect

The Aggregate demadn curve Price Level

Quantity of Output

Aggregate demand

An increase in government purchases of $20 billion initially increases aggregate demand by$20 billion.

But the multiplier effect can amplify the shift in aggregate demand.

•  Mulitiplier effect is the addtional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. •  Higher govenrment demand spurs higher demand for investment goods.This positive feedback from demand to investment is sometimes called the investment accelerator.

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A formula for the spending multiplier

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Other application of the multiplier effect

Y=C + I + G + NX

A small initial change in consumption,investment,government purchases,or net exports can end up having a large effect on aggregate demand and ,therefore, the economy's production of goods and services. -Recession overseas -Stock boom -Financial crisis

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The crowding out effect

The money market The Aggregate demadn curve

Quantity of money

Price Level

Quantity of Output

r2

r1

Money supply

Money demand

aggregate demand

interest rate

3 which increase the equilibrium interest rate

2. the increase in spending increases money demand

1 When an increaes in government purchase increases aggregate demand

4 which in turn partly offsets the initial increase in aggregate demand.

•  Crowding effect is the offset in aggregate demand that results when expansinaory fiscal policy raises the interest rate and thereby reduces investment spending.

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Changes in taxes •  A tax decrease increases consumer spending,the tax cut

shifts the aggregate demand curve to the right.

•  The size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding out effects.

•  The effect of tax change depends on whether permanent or temporary. –  Permanent:

House hold increase their spending by a large amount.

–  Temporary:

House hold increase their spending by only a small amount.

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Index

1. How monetary policy influences aggregate demand

2. How fiscal policy influences aggregate demand

3. Using policy to stabilize the economy

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Should policy makers use these instruments to control aggregate demand and stabilize the eonomy?

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The case for active stabilization policy

•  The emplyment act of 1946 –  It is the continuing policy and responsibility of the federal

government to ・・・ promote full employment and production.

•  The general theory of employment,interest rate and money –  Keynes claimed that the government should actively stimulate

aggregate demand when aggregate demand appeared insufficient to maintain production at its full employment level.

•  Former Fed Chairman William Mcchesney Martin –  The Federal Reserve's job is to take away the punch bowl just as

the party gets going.

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The case against active stabilization policy

•  To avoid active use of monetary policy and fiscal policy to try to stabilize the economy.

•  Policy instruments should be set to acheive long-run goals –  such as rapid economic growth and low inflation.

•  Both monetary and fiscal policies affect the economy with long lag.

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Automatic stabilizers

•  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.

go to recession

workers are laid off

income support by government

This automatic increase in government spending stimulates aggregate at exactly the time when aggregate demand is insufficient to maintain full employment.