Princ ch34 Presentation

25/08/2020
CHAPTER
34 In this chapter,
look for the answers to these questions:
The Influence of Monetary and ▪ How does the interest-rate effect help explain the
Fiscal Policy on Aggregate Demand slope of the aggregate-demand curve?
▪ How can the central bank use monetary policy to
Economics
PRINCIPLES OF
shift the AD curve?
N. Gregory Mankiw ▪ In what two ways does fiscal policy affect aggregate
demand?
▪ What are the arguments for and against
Premium PowerPoint Slides using policy to try to stabilize the economy?
by Ron Cronovich
© 2009 South-Western, a part of Cengage Learning, all rights reserved 1
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Introduction Aggregate Demand

▪ Earlier chapters covered: ▪ Recall, the AD curve slopes downward for three
▪ the long-run effects of fiscal policy reasons:
on interest rates, investment, economic growth ▪ The wealth effect the most important
▪ the long-run effects of monetary policy ▪ The interest-rate effect of these effects for
on the price level and inflation rate ▪ The exchange-rate effect the U.S. economy
▪ This chapter focuses on the short-run effects ▪ Next:

of fiscal and monetary policy, A supply-demand model that helps explain the
which work through aggregate demand. interest-rate effect and how monetary policy
affects aggregate demand.
THE INFLUENCE OF MONETARY AND FISCAL POLICY 2 THE INFLUENCE OF MONETARY AND FISCAL POLICY 3
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The Theory of Liquidity Preference The Theory of Liquidity Preference

▪ A simple theory of the interest rate (denoted r) ▪ Money demand reflects how much wealth
people want to hold in liquid form.
▪ r adjusts to balance supply and demand
for money ▪ For simplicity, suppose household wealth
includes only two assets:
▪ Money supply: assume fixed by central bank,
does not depend on interest rate ▪ Money – liquid but pays no interest
▪ Bonds – pay interest but not as liquid
▪ A household’s “money demand” reflects its
preference for liquidity.
▪ The variables that influence money demand:
Y, r, and P.
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Money Demand ACTIVE LEARNING 1

▪ Suppose real income (Y) rises. Other things equal, The determinants of money demand
what happens to money demand? A. Suppose r rises, but Y and P are unchanged.
▪ If Y rises: What happens to money demand?
▪ Households want to buy more g&s, B. Suppose P rises, but Y and r are unchanged.
so they need more money. What happens to money demand?
▪ To get this money, they attempt to sell some of
their bonds.
▪ I.e., an increase in Y causes
an increase in money demand, other things equal.
THE INFLUENCE OF MONETARY AND FISCAL POLICY 6 7
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ACTIVE LEARNING 1 ACTIVE LEARNING 1

Answers Answers
A. Suppose r rises, but Y and P are unchanged. B. Suppose P rises, but Y and r are unchanged.
What happens to money demand? What happens to money demand?
r is the opportunity cost of holding money. If Y is unchanged, people will want to buy the
same amount of g&s.
An increase in r reduces money demand:
households attempt to buy bonds to take Since P is higher, they will need more money to
advantage of the higher interest rate. do so.
Hence, an increase in r causes a decrease in Hence, an increase in P causes an increase in
money demand, other things equal. money demand, other things equal.
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How r Is Determined How the Interest-Rate Effect Works

A fall in P reduces money demand, which lowers r.
Interest MS curve is vertical: Interest P
rate MS rate MS
Changes in r do not
affect MS, which is
r1 fixed by the Fed. r1
P1
Eq’m MD curve is
interest downward sloping: r2 P2
rate MD1 MD1
A fall in r increases AD
money demand. MD2
M M Y1 Y2 Y
Quantity fixed
by the Fed A fall in r increases I and the quantity of g&s demanded.
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Monetary Policy and Aggregate Demand The Effects of Reducing the Money Supply
▪ To achieve macroeconomic goals, the Fed can The Fed can raise r by reducing the money supply.
use monetary policy to shift the AD curve. Interest P
rate MS2 MS1
▪ The Fed’s policy instrument is MS.
▪ The news often reports that the Fed targets the r2
interest rate.
P1
▪ More precisely, the federal funds rate – which r1
banks charge each other on short-term loans
AD1
▪ To change the interest rate and shift the AD curve, MD AD2
the Fed conducts open market operations M Y2 Y1 Y
to change MS.
An increase in r reduces the quantity of g&s demanded.
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Monetary policy Answers
For each of the events below, A. Congress tries to balance the budget by
- determine the short-run effects on output cutting govt spending.
- determine how the Fed should adjust the money
This event would reduce agg demand and
supply and interest rates to stabilize output
output.
A. Congress tries to balance the budget by cutting
To offset this event, the Fed should increase
govt spending.
MS and reduce r to increase agg demand.
B. A stock market boom increases household
wealth.
C. War breaks out in the Middle East,
causing oil prices to soar.
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Answers Answers
B. A stock market boom increases household C. War breaks out in the Middle East,
wealth. causing oil prices to soar.
This event would increase agg demand, This event would reduce agg supply,
raising output above its natural rate. causing output to fall.
To offset this event, the Fed should reduce MS To offset this event, the Fed should increase
and increase r to reduce agg demand. MS and reduce r to increase agg demand.
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Fiscal Policy and Aggregate Demand 1. The Multiplier Effect

▪ Fiscal policy: the setting of the level of govt ▪ If the govt buys $20b of planes from Boeing,
Boeing’s revenue increases by $20b.
spending and taxation by govt policymakers
▪ This is distributed to Boeing’s workers (as wages)
▪ Expansionary fiscal policy and owners (as profits or stock dividends).
▪ an increase in G and/or decrease in T
▪ shifts AD right ▪ These people are also consumers and will spend
a portion of the extra income.
▪ Contractionary fiscal policy ▪ This extra consumption causes further increases
▪ a decrease in G and/or increase in T in aggregate demand.
▪ shifts AD left
Multiplier effect: the additional shifts in AD
▪ Fiscal policy has two effects on AD... that result when fiscal policy increases income
and thereby increases consumer spending
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1. The Multiplier Effect Marginal Propensity to Consume

▪ How big is the multiplier effect?
A $20b increase in G P It depends on how much consumers respond to
initially shifts AD increases in income.
to the right by $20b.
AD1 AD2 AD3 ▪ Marginal propensity to consume (MPC):
The increase in Y
the fraction of extra income that households
causes C to rise,
P1 consume rather than save
which shifts AD
further to the right. $20 billion E.g., if MPC = 0.8 and income rises $100,
C rises $80.
Y1 Y2 Y3 Y
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A Formula for the Multiplier A Formula for the Multiplier

Notation: G is the change in G, The size of the multiplier depends on MPC.
Y and C are the ultimate changes in Y and C E.g., if MPC = 0.5 multiplier = 2
Y = C + I + G + NX identity if MPC = 0.75 multiplier = 4
if MPC = 0.9 multiplier = 10
Y = C + G I and NX do not change
Y = MPC Y + G because C = MPC Y A bigger MPC means

1 1 changes in Y cause
Y = G solved for Y Y = G
1 – MPC 1 – MPC bigger changes in C,
which in turn cause
The multiplier The multiplier more changes in Y.
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Other Applications of the Multiplier Effect 2. The Crowding-Out Effect

▪ The multiplier effect: ▪ Fiscal policy has another effect on AD
Each $1 increase in G can generate that works in the opposite direction.
more than a $1 increase in agg demand.
▪ A fiscal expansion raises r,
▪ Also true for the other components of GDP. which reduces investment,
Example: Suppose a recession overseas which reduces the net increase in agg demand.
reduces demand for U.S. net exports by $10b. ▪ So, the size of the AD shift may be smaller than
Initially, agg demand falls by $10b. the initial fiscal expansion.
The fall in Y causes C to fall, which further ▪ This is called the crowding-out effect.
reduces agg demand and income.
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How the Crowding-Out Effect Works Changes in Taxes

A $20b increase in G initially shifts AD right by $20b ▪ A tax cut increases households’ take-home pay.
Interest P
rate MS ▪ Households respond by spending a portion of this
extra income, shifting AD to the right.
AD2
r2 AD1 AD3 ▪ The size of the shift is affected by the multiplier and
crowding-out effects.
P1
r1 ▪ Another factor: whether households perceive the
MD2 $20 billion
tax cut to be temporary or permanent.
MD1 ▪ A permanent tax cut causes a bigger increase in
M Y1 Y3 Y2 Y C – and a bigger shift in the AD curve –
than a temporary tax cut.
But higher Y increases MD and r, which reduces AD.
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Exercise Answers
The economy is in recession. The economy is in recession.
Shifting the AD curve rightward by $200b Shifting the AD curve rightward by $200b
would end the recession. would end the recession.
A. If MPC = .8 and there is no crowding out, A. If MPC = .8 and there is no crowding out,
how much should Congress increase G how much should Congress increase G
to end the recession? to end the recession?
B. If there is crowding out, will Congress need to Multiplier = 1/(1 – .8) = 5
increase G more or less than this amount? Increase G by $40b
to shift agg demand by 5 x $40b = $200b.
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ACTIVE LEARNING 3 Fiscal Policy and Aggregate Supply

Answers ▪ Most economists believe the short-run effects of
The economy is in recession. fiscal policy mainly work through agg demand.
Shifting the AD curve rightward by $200b
would end the recession.
▪ But fiscal policy might also affect agg supply.
B. If there is crowding out, will Congress need to
▪ Recall one of the Ten Principles from Chap 1:
People respond to incentives.
increase G more or less than this amount?
Crowding out reduces the impact of G on AD.
▪ A cut in the tax rate gives workers incentive to
work more, so it might increase the quantity of
To offset this, Congress should increase G by g&s supplied and shift AS to the right.
a larger amount.
▪ People who believe this effect is large are called
“Supply-siders.”
30 THE INFLUENCE OF MONETARY AND FISCAL POLICY 31
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Fiscal Policy and Aggregate Supply Using Policy to Stabilize the Economy
▪ Govt purchases might affect agg supply. ▪ Since the Employment Act of 1946, economic
Example: stabilization has been a goal of U.S. policy.
▪ Govt increases spending on roads. ▪ Economists debate how active a role the govt
▪ Better roads may increase business productivity, should take to stabilize the economy.
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 The Case for Active Stabilization Policy
▪ Keynes: “Animal spirits” cause waves of ▪ Proponents of active stabilization policy
pessimism and optimism among households and believe the govt should use policy
firms, leading to shifts in aggregate demand and to reduce these fluctuations:
fluctuations in output and employment. ▪ When GDP falls below its natural rate,
▪ Also, other factors cause fluctuations, e.g., use expansionary monetary or fiscal policy
▪ booms and recessions abroad to prevent or reduce a recession.
▪ stock market booms and crashes ▪ When GDP rises above its natural rate,
use contractionary policy to prevent or reduce
▪ If policymakers do nothing, these fluctuations are an inflationary boom.
destabilizing to businesses, workers, consumers.
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Keynesians in the White House The Case Against Active Stabilization Policy
1961: ▪ Monetary policy affects economy with a long lag:
John F Kennedy pushed for a ▪ Firms make investment plans in advance,
tax cut to stimulate agg demand.
so I takes time to respond to changes in r.
Several of his economic advisors
were followers of Keynes. ▪ Most economists believe it takes at least
6 months for mon policy to affect output and
employment.
2001: ▪ Fiscal policy also works with a long lag:

George W Bush pushed for a ▪ Changes in G and T require Acts of Congress.
tax cut that helped the economy ▪ The legislative process can take months or
recover from a recession that years.
had just begun.
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The Case Against Active Stabilization Policy Automatic Stabilizers

▪ Due to these long lags, critics of active policy ▪ Automatic stabilizers:
argue that such policies may destabilize the changes in fiscal policy that stimulate
economy rather than help it: agg demand when economy goes into recession,
By the time the policies affect agg demand, without policymakers having to take any
the economy’s condition may have changed. deliberate action
▪ These critics contend that policymakers should

focus on long-run goals like economic growth
and low inflation.
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Automatic Stabilizers: Examples CONCLUSION

▪ The tax system ▪ Policymakers need to consider all the effects of
▪ In recession, taxes fall automatically, their actions. For example,
which stimulates agg demand. ▪ When Congress cuts taxes, it should consider
▪ Govt spending the short-run effects on agg demand and
employment, and the long-run effects
▪ In recession, more people apply for public
on saving and growth.
assistance (welfare, unemployment insurance).
▪ Govt spending on these programs automatically ▪ When the Fed reduces the rate of money
rises, which stimulates agg demand. 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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CHAPTER SUMMARY CHAPTER SUMMARY
▪ In the theory of liquidity preference, ▪ An increase in the money supply causes the
the interest rate adjusts to balance interest rate to fall, which stimulates investment
the demand for money with the supply of money. and shifts the aggregate demand curve rightward.
▪ The interest-rate effect helps explain why the ▪ Expansionary fiscal policy – a spending increase or
aggregate-demand curve slopes downward: tax cut – shifts aggregate demand to the right.
an increase in the price level raises money Contractionary fiscal policy shifts aggregate
demand, which raises the interest rate, which demand to the left.
reduces investment, which reduces the aggregate
quantity of goods & services demanded.
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CHAPTER SUMMARY CHAPTER SUMMARY
▪ When the government alters spending or taxes, ▪ Economists disagree about how actively
the resulting shift in aggregate demand can be policymakers should try to stabilize the economy.
larger or smaller than the fiscal change: ▪ Some argue that the government should use
▪ The multiplier effect tends to amplify the effects fiscal and monetary policy to combat destabilizing
of fiscal policy on aggregate demand. fluctuations in output and employment.
▪ The crowding-out effect tends to dampen the ▪ Others argue that policy will end up destabilizing
effects of fiscal policy on aggregate demand. the economy because policies work with long lags.
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Princ ch34 Presentation

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25/08/2020

Introduction Aggregate Demand

▪ This chapter focuses on the short-run effects ▪ Next:

The Theory of Liquidity Preference The Theory of Liquidity Preference

Money Demand ACTIVE LEARNING 1

THE INFLUENCE OF MONETARY AND FISCAL POLICY 6 7

ACTIVE LEARNING 1 ACTIVE LEARNING 1

How r Is Determined How the Interest-Rate Effect Works

ACTIVE LEARNING 2 ACTIVE LEARNING 2

ACTIVE LEARNING 2 ACTIVE LEARNING 2

Fiscal Policy and Aggregate Demand 1. The Multiplier Effect

1. The Multiplier Effect Marginal Propensity to Consume

A Formula for the Multiplier A Formula for the Multiplier

Y = MPC Y + G because C = MPC Y A bigger MPC means

Other Applications of the Multiplier Effect 2. The Crowding-Out Effect

How the Crowding-Out Effect Works Changes in Taxes

ACTIVE LEARNING 3 ACTIVE LEARNING 3

ACTIVE LEARNING 3 Fiscal Policy and Aggregate Supply

2001: ▪ Fiscal policy also works with a long lag:

The Case Against Active Stabilization Policy Automatic Stabilizers

▪ These critics contend that policymakers should

Automatic Stabilizers: Examples CONCLUSION

CHAPTER SUMMARY CHAPTER SUMMARY

CHAPTER SUMMARY CHAPTER SUMMARY

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