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Fiscal and Monetary Policy
Dr. Katherine Sauer
Principles of Macroeconomics
ECO 2010
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Overview:
I. Monetary Policy and Aggregate DemandII. Fiscal Policy and Aggregate Demand
III. Should Policymakers use policy to stabilize the economy?
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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
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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.
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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
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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
3) When the interest rate falls but the price level is constant,
Investment will increase, and AD will shift right.
Q2
AD2
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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
The result is an increase in RGDP at a given price level.
Q2
AD2
Y2
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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
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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
3) When the interest rate rises, Investment will fall and AD will
shift left.
Q2
AS
AD2
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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
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