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COURSE: MACROECONOMICS
ID: IM1009
Chapter 5:
Macroeconomic Policies

Contents
Session Content Readings

1-2-3 The System of National Accounts Mankiw (VN) C10, 11,12 (ENG) 22, 23, 24

4 Aggregate Demand and Aggregate Supply Mankiw (VN) C20 (ENG) 33

5-6 Inflation and Unemployment Mankiw (VN) C10, 15,17,22 (ENG) 28, 30, 35
•

7-8-9 Financial, Monetary, and Banking System Mankiw (VN) C13,16,17 (ENG) 26,29,30

10 Macroeconomics policies Mankiw (VN) C21 (ENG) 34

11-12 Open Macroeconomics Mankiw (VN) C18,19 (ENG) 31,32

13-14-
Presentation
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In this chapter,
look for the answers to these questions:
• How does the interest-rate effect help explain the slope
of the aggregate-demand curve?
• How can the central bank use monetary policy to shift
the AD curve?
• In what two ways does fiscal policy affect aggregate
demand?
• What are the arguments for and against using policy to
try to stabilize the economy?

Aggregate Demand
• Recall, the AD curve slopes downward for three reasons:
• The wealth effect the most important of
• The interest-rate effect these effects for the
• The exchange-rate effect economy
• A supply-demand model that helps explain the interest-
rate effect and how monetary policy affects aggregate
demand.

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Theory of Liquidity Preference

• The theory of liquidity preference
• A simple theory of the interest rate (r)
• r adjusts to balance supply and demand
for money
• Nominal interest rate, real interest rate
• Assumption: expected rate of inflation is constant
• Money supply:
• Assumed fixed by central bank, does not depend on
interest rate

Theory of Liquidity Preference

• Money demand
• Reflects how much wealth people want to hold in
liquid form
• Assume household wealth includes only two assets:
• Money – liquid but pays no interest
• Bonds – pay interest but not as liquid
• A household’s “money demand” reflects its preference
for liquidity
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Theory of Liquidity Preference

• Variables that influence money demand:
• Y, r, and P.
• Suppose real income (Y) rises:
• Households want to buy more goods and services, so they
need more money
• To get this money, they attempt to sell some of their bonds.
An increase in Y causes an increase in money demand,
other things equal.
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Active Learning
The determinants of money demand

A. Suppose r rises, but Y and P are unchanged. What happens to money

demand?
• r is the opportunity cost of holding money.
• An increase in r reduces money demand: households attempt to buy bonds to
take advantage of the higher interest rate.
• Hence, an increase in r causes a decrease in money demand, other things equal.

B. Suppose P rises, but Y and r are unchanged. What happens to money

demand?
• If Y is unchanged, people will want to buy the same amount of goods and
services.
• Since P is higher, they will need more money to do so.
• Hence, an increase in P causes an increase in money demand, other things
equal.
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Monetary Policy
• Objectives: Price stabilization

• The Central Bank controls over the supply of money is the key mechanism to
monetary policy.
• Monetary policy is the use of money and credit controls to influence macroeconomic activity.
• Monetary policy involves change in the rate of growth of the money supply (M1 and M2) and
short-term interest rates

• Expansionary monetary policy: Increase the growth rate of M

• Contractionary monetary policy: Decrease the growth rate of M

How r Is Determined
MS curve is vertical:
Interest
Changes in r do not
rate MS affect MS, which is
fixed by the Fed.
r1 MD curve is
downward sloping:
Eq’m
interest
A fall in r increases
rate MD1
money demand.

M
Quantity fixed
by the Fed
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How the Interest-Rate Effect Works

A fall in P reduces money demand, which lowers r.
Interest P
rate MS

r1
P1

r2 P2
MD1 AD
MD2
M Y1 Y2 Y

A fall in r increases I and the quantity of g&s demanded.

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Monetary Policy
• Policy decision: usually made by the central bank
• Tools
• Discount rate – credit policies
• Open market operation
• Reserved ratio
• Lags in fiscal policies:
• Recognition lag: 3 – 6 months
• Decision lag: generally very short
• Implementation lag: generally very short
• Impact lag: usually 12 – 18 months

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The Effects of Reducing the Money Supply

The Fed can raise r by reducing the money supply.
Interest P
rate MS2 MS1

r2
P1
r1
AD1
MD AD2
M Y2 Y1 Y

An increase in r reduces the quantity of g&s demanded.

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1. When the central bank buys government bonds,
the reserves of the banking system
a. increase, so the money supply decreases.
b. decrease, so the money supply increases.
c. decrease, so the money supply decreases.
d. increase, so the money supply increases.
2. If the central bank conducts open-market
purchases, which of these increase in the short
run—interest rates, prices, and investment
spending?
a. interest rates, prices, and investment spending
b. interest rates and prices, not investment spending
c. prices and investment spending, not interest rates
d. interest rates, neither prices nor investment
spending
3. If in response to an adverse aggregate supply
shock the Central Bank increased the money
supply,
a. unemployment and inflation would both be rise.
b. unemployment and inflation would both fall.
c. unemployment would fall and inflation would rise.
d. unemployment would rise and inflation would fall.
4. Open-market purchases by the Central Bank make
the money supply
a. increase, which makes the value of money increase.
b. decrease, which makes the value of money decrease.
c. decrease, which makes the value of money increase.
d. increase, which makes the value of money decrease.
5. Which of the following is correct?
a. If the Central Bank purchases bonds in the open
market, then the money supply curve shifts right. A
change in the price level does not shift the money
supply curve.
b. If the Central Bank sells bonds in the open market,
then the money supply curve shifts right. A change in
the price level does not shift the money supply curve.
c. If the Central Bank purchases bonds, then the money
supply curve shifts right. An increase in the price level
shifts the money supply curve right.
d. If the Central Bank sells bonds, then the money supply
curve shifts right. A decrease in the price level shifts
the money supply curve right.

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Fiscal Policy
• Objectives:
• Stimulate the economy
• Stabilize the price level
• Outcomes: Investment, Consumption, Government spending
• The use of government taxes and spending to alter macroeconomic
outcomes.
• Expansionary fiscal policy: Increase G, decrease T
• Contractionary fiscal policy: Decrease G, increase T
• Policy decision: usually made by the politicians

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Fiscal Policy
• Problems
• Inflation
• Crowding out
• Lags in fiscal policies:
• Recognition lag: 3 – 6 months
• Decision lag: can be long depending on the nature of the political
system
• Implementation lag: can be either short or long
• Impact lag: usually 3 – 6 months

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Fiscal Policy and Aggregate Demand

• Fiscal policy: the setting of the level of govt spending and taxation by
govt policymakers
• Expansionary fiscal policy
• an increase in G and/or decrease in T,
shifts AD right
• Contractionary fiscal policy
• a decrease in G and/or increase in T,
shifts AD left
• Fiscal policy has two effects on AD...

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1. The Multiplier Effect

• If the govt buys $20b of planes from Boeing, Boeing’s revenue increases by
$20b.
• This is distributed to Boeing’s workers (as wages) and owners (as profits or
stock dividends).
• These people are also consumers and will spend a portion of the extra income.
• This extra consumption causes further increases in aggregate demand.

Multiplier effect: the additional shifts in AD

that result when fiscal policy increases income and thereby
increases consumer spending

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1. The Multiplier Effect

A $20b increase in G initially shifts P
AD
to the right by $20b.
The increase in Y causes C to rise, AD2 AD3
AD1
which shifts AD further to the
right.
P1
$20 billion

Y1 Y2 Y3 Y

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Marginal Propensity to Consume

• How big is the multiplier effect?
It depends on how much consumers respond to increases in income.
• Marginal propensity to consume (MPC):
the fraction of extra income that households consume rather than
save
E.g., if MPC = 0.8 and income rises $100,
C rises $80.

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A Formula for the Multiplier

Notation: DG is the change in G,
DY and DC are the ultimate changes in Y and C
Y = C + I + G + NX identity
DY = DC + DG I and NX do not change
DY = MPC DY + DG because DC = MPC DY
solved for DY
1
DY = DG
1 – MPC

The multiplier

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A Formula for the Multiplier

The size of the multiplier depends on MPC.
E.g., if MPC = 0.5 multiplier = 2
if MPC = 0.75 multiplier = 4
if MPC = 0.9 multiplier = 10

A bigger MPC means

changes in Y cause
1
DY = DG bigger changes in C,
1 – MPC
which in turn cause
bigger changes in Y.
The multiplier

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Other Applications of the Multiplier Effect

• The multiplier effect:

Each $1 increase in G can generate more than a $1 increase in
aggregate demand.
• Also true for the other components of GDP.
Example: Suppose a recession overseas reduces demand for
U.S. net exports by $10b.
Initially, aggregate demand falls by $10b.
The fall in Y causes C to fall, which further reduces agg demand
and income.

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2. The Crowding-Out Effect

• Fiscal policy has another effect on AD
that works in the opposite direction.
• A fiscal expansion raises r,
which reduces investment,
which reduces the net increase in agg demand.
• So, the size of the AD shift may be smaller than the initial fiscal
expansion.
• This is called the crowding-out effect.

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How the Crowding-Out Effect Works

A $20b increase in G initially shifts AD right by $20b
Interest P
rate MS

AD2
r2 AD1 AD3

P1
r1
MD2 $20 billion

MD1
M Y1 Y3 Y2 Y

But higher Y increases MD and r, which reduces AD.

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Changes in Taxes
• A tax cut increases households’ take-home pay.
• Households respond by spending a portion of this extra income, shifting
AD to the right.
• The size of the shift is affected by the multiplier and crowding-out
effects.
• Another factor: whether households perceive the tax cut to be
temporary or permanent.
• A permanent tax cut causes a bigger increase in C—and a bigger shift in the
AD curve—than a temporary tax cut.

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6. Which of the following correctly explains the crowding-out effect?

a. An increase in government expenditures decreases the interest rate and so increases investment spending.
b. An increase in government expenditures increases the interest rate and so reduces investment spending.
c. A decrease in government expenditures increases the interest rate and so increases investment spending.
d. A decrease in government expenditures decreases the interest rate and so reduces investment spending.
7. Suppose that there is a multiplier effect that is greater than one and that there are no crowding out or
investment accelerator effects. Which of the following would shift the aggregate demand to the right
by more than the increase in expenditures?
a. an increase in government expenditures
b. an increase in net exports
c. an increase in investment spending
d. All of the above are correct.
8. According to the crowding-out effect, a decrease in government spending
a. increases the interest rate and so increases investment spending.
b. increases the interest rate and so decreases investment spending.
c. decreases the interest rate and so increases investment spending.
d. decreases the interest rate and so decreases investment spending.
9. Sometimes that during wars, the government expenditures are larger than normal. To reduce the
effects this spending creates on interest rates,
a. the central bank could increase the money supply by selling bonds.
b. the central bank could decrease the money supply by buying bonds.
c. the central bank could decrease the money supply by selling bonds.
d. the central bank could increase the money supply by buying bonds.

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10. Assume that the multiplier is 5 and that the total crowding-out effect is $20 billion. An increase in
government purchases of $10 billion when the multiplier is 5 will shift the aggregate demand curve
a. to the right by $150 billion.
b. to the right by $30 billion.
c. to the right by $70 billion.
d. None of the above is correct.
11. If the MPC is 0.80 and there are no crowding-out or accelerator effects, then an initial increase in aggregate
demand of $100 billion will eventually shift the aggregate demand curve to the right by
a. $80 billion..
b. $125 billion.
c. $500 billion
d. $800 billion.
12. Assuming crowding-out but no multiplier or investment-accelerator effects, a $100 billion increase in
government expenditures shifts aggregate
a. demand to the right by more than $100 billion.
b. demand to the right by less than $100 billion.
c. supply to the left by more than $100 billion.
d. supply to the left by less than $100 billion.
13. Tax cuts
a. and increases in government expenditures shift aggregate demand to the right.
b. and increases in government expenditures shift aggregate demand to the left.
c. shift aggregate demand to the right while increases in government expenditures shift aggregate demand to the left.
d. shift aggregate demand to the left while increases in government expenditures shift aggregate demand to the right.

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14. The multiplier effect

a. and the crowding-out effect both amplify the effects of an increase in government expenditures.
b. and the crowding-out effect both diminish the effects of an increase in government expenditures.
c. diminishes the effects of an increase in government expenditures, while the crowding-out effect amplifies the
effects.
d. amplifies the effects of an increase in government expenditures, while the crowding-out effect diminishes the
effects.
15. An increase in the MPC
a. increases the multiplier, so that changes in government expenditures have a larger effect on aggregate
demand.
b. increases the multiplier, so that changes in government expenditures have a smaller effect on aggregate
demand.
c. decreases the multiplier, so that changes in government expenditures have a larger effect on aggregate
demand.
d. decreases the multiplier, so that changes in government expenditures have a smaller effect on aggregate
demand.

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16. In a simple Macroeconomic model, if the
Mpc=3/5, closing a $60 billion GDP gap
could be accomplished through new
government spending of:
a. $15 billion.
b. $24 billion.
c. $36 billion.
d. $40 billion.
17. The AD curve shifts by $40 billion to the
left. The government wants to change its
spending to offset this decrease in
demand. The MPC is 0.60. What should the
government do if it wants to offset the
decrease in real GDP?
a. Raise both taxes and expenditures by $40
billion dollars.
b. Raise both taxes and expenditures by $40
billion dollars.
c. Reduce both taxes and expenditures by $10
billion dollars.
d. Reduce both taxes and expenditures by $10
billion dollars.
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18. In a simple Macroeconomic model with
Mpc=.80, a $100 billion autonomous tax
hike will:
a. raise equilibrium income by $500 billion.
b. provide corporate executives with incentives
to work harder.
c. lower equilibrium income by $500 billion.
d. reduce equilibrium income by $400 billion.
19. Suppose the MPC is .75. There are no
crowding out or investment accelerator
effects. If the government increases
expenditures by $200 billion, how far does
aggregate demand shift? If the
government decreases taxes by $200
billion, how far does aggregate demand
shift?
a. $800 billion and $800 billion
b. $800 billion and $600 billion
c. $600 billion and $600 billion
d. $600 billion and $450 billion

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ACTIVE LEARNING
Fiscal policy effects
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
B. If there is crowding out, will Congress need to increase G more or
less than this amount?

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ACTIVE LEARNING
Answers
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
Multiplier = 1/(1 – .8) = 5
Increase G by $40b
to shift agg demand by 5 x $40b = $200b.

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ACTIVE LEARNING
Answers
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
B. If there is crowding out, will Congress need to increase G more or
less than this amount?
Crowding out reduces the impact of G on AD.
To offset this, Congress should increase G by a larger amount.

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Fiscal Policy and Aggregate Supply

• Most economists believe the short-run effects of fiscal policy mainly
work through agg demand.
• But fiscal policy might also affect agg supply.
• Recall one of the Ten Principles from Chapter 1:
People respond to incentives.
• A cut in the tax rate gives workers incentive to work more, so it might
increase the quantity of g&s supplied and shift AS to the right.
• People who believe this effect is large are called “Supply-siders.”

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Fiscal Policy and Aggregate Supply

• Govt purchases might affect agg supply. Example:
• Govt increases spending on roads.
• Better roads may increase business productivity, which increases the quantity
of g&s supplied, shifts AS to the right.
• This effect is probably more relevant in the long run: it takes time to
build the new roads and put them into use.

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The Case for Active Stabilization Policy

• Keynes: “Animal spirits” cause waves of pessimism and optimism
among households and firms, leading to shifts in aggregate demand and
fluctuations in output and employment.
• Also, other factors cause fluctuations, e.g.,
• booms and recessions abroad
• stock market booms and crashes
• If policymakers do nothing, these fluctuations are destabilizing to
businesses, workers, consumers.

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The Case Against Active Stabilization Policy

• Monetary policy affects economy with a long lag:
• Firms make investment plans in advance, so I takes time to
respond to changes in r.
• Most economists believe it takes at least 6 months for
monetary policy to affect output and employment.
• Fiscal policy also works with a long lag:
• Changes in G and T require acts of Congress.
• The legislative process can take months or years.

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The Case Against Active Stabilization Policy

• Due to these long lags, critics of active policy argue that such policies
may destabilize the economy rather than help it:
By the time the policies affect agg demand,
the economy’s condition may have changed.
• These critics contend that policymakers should focus on long-run
goals like economic growth and low inflation.

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Automatic Stabilizers
• Automatic stabilizers:
changes in fiscal policy that stimulate aggregate demand when economy
goes into recession, without policymakers having to take any deliberate
action

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Automatic Stabilizers: Examples

• The tax system
• In recession, taxes fall automatically,
which stimulates aggregate demand.
• Government spending
• In recession, more people apply for public assistance (welfare,
unemployment insurance).
• Government spending on these programs automatically rises,
which stimulates aggregate demand.

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20. Suppose stock prices rise. To offset the resulting change in output the Federal Reserve could
a. increase the money supply. This increase would also move the price level closer to its value before the rise in
stock prices.
b. increase the money supply. However, this increase would move the price level farther from its value before the
rise in stock prices.
c. decrease the money supply. This decrease would also move the price level closer to its value before the rise in
stock prices.
d. decrease the money supply. However, this decrease would move the price level farther from its value before the
rise in stock prices.
21. The primary argument against active monetary and fiscal policy is that
a. attempts to stabilize the economy do not constitute a proper role for government in a democratic society.
b. these policies affect the economy with a long lag.
c. these policies affect the economy too quickly and with too much impact.
d. history demonstrates that interest rates respond unpredictably to active policies, leading to unpredictable effects
on income.
22. Aggregate demand shifts to the left and policymakers want to stabilize output. What can they do?
a. repeal an investment tax credit or increase the money supply
b. repeal an investment tax credit or decrease the money supply
c. institute an investment tax credit or increase the money supply
d. institute an investment tax credit or decrease the money supply
23. Suppose there were a large increase in net exports. If the Central Bank wanted to stabilize output, it could
a. buy bonds to increase the money supply.
b. buy bonds to decrease the money supply.
c. sell bonds to increase the money supply.
d. sell bonds to decrease the money supply.

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24. The economy is in long-run equilibrium. Advances in technology shift the long-run aggregate supply
curve $50 billion to the right. Optimistic investors have shifted the aggregate demand curve $100
billion to the right. In order to stabilize the price level at its original value, the government wants to
reduce its spending. If the crowding-out effect is always half of the multiplier effect, and if the MPC
equals 0.75, then the government must cut its spending by
a. $4 billion.
b. $25 billion.
c. $50 billion.
d. $100 billion.
25. The economy is in long-run equilibrium. Congress passes regulations that make it more costly to
conduct business, so the long-run aggregate supply curve shifts $60 billion to the left. At the same
time, government purchases increase by $60 billion. If the MPC equals 0.8 and the crowding-out effect
is $60 billion, we would expect that in the long run,
a. both real GDP and the price level would be higher.
b. both real GDP and the price level would be lower.
c. real GDP would be lower but the price level would be higher.
d. real GDP would be lower but the price level would be the same.
26. If policymakers expand aggregate demand,
a. in the long run, prices will be higher and unemployment will be lower.
b. in the long run, prices will be higher and unemployment will be unchanged.
c. in the long run, inflation and unemployment will be unchanged.
d. None of the above is correct.

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CONCLUSION
• Policymakers need to consider all the effects of their actions. For
example,
• When Congress cuts taxes, it should consider the short-run effects on agg
demand and employment, and the long-run effects
on saving and growth.
• When the Fed reduces the rate of money growth, it must take into account not
only the long-run effects on inflation but the short-run effects on output and
employment.

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Summary
• Theory of liquidity preference: the interest rate adjusts to balance the
demand for money with the supply of money.
• The interest-rate effect helps explain why the aggregate-demand curve
slopes downward:
• An increase in the price level raises money demand, which raises the interest
rate, which reduces investment, which reduces the aggregate quantity of goods &
services demanded.
• An increase in the money supply causes the interest rate to fall, which
stimulates investment and shifts the aggregate demand curve rightward.
• Expansionary fiscal policy—a spending increase or tax cut—shifts
aggregate demand to the right. Contractionary fiscal policy shifts
aggregate demand to the left.

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Summary
• When the government alters spending or taxes, the resulting shift in
aggregate demand can be larger or smaller than the fiscal change:
• The multiplier effect tends to amplify the effects of fiscal policy on aggregate
demand.
• The crowding-out effect tends to dampen the effects of fiscal policy on aggregate
demand.
• Economists disagree about how actively policymakers should try to
stabilize the economy.
• Some argue that the government should use
fiscal and monetary policy to combat destabilizing fluctuations in output
and employment.
• Others argue that policy will end up destabilizing the economy because
policies work with long lags.
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