# 5.

2 The Influence of Monetary & Fiscal
Policy on Aggregate Demand

Chapter 34

Aggregate Demand
• Aggregate-demand curve slopes downward:
–The wealth effect
the most
–The interest-rate effect important of
these effects for
–The exchange-rate effect the U.S. economy

• Aggregate-demand

The Theory of Liquidity Preference
• Keynes’s theory
– Interest rate (r) adjusts to balance
the money supply & money
demand

–Money supply: assume fixed by
central bank (Fed), does not
depend on interest rate

The Theory of Liquidity Preference • Money demand reflects how much wealth people want to hold in liquid form (preference for liquidity). • The variables that influence money demand: Y (GDP). and P (price level). . r (interest rate).

Other things equal. what happens to money demand? • If r rises: –Raises the cost of holding money. Money Demand • Suppose interest rate (r) rises. • An increase in r causes a decrease in money demand. other things equal. . –so. households attempt to buy bonds to take advantage of the higher interest rate.

but Y and r are unchanged. What happens to money demand? . Practice Problem #1 The determinants of money demand A. Suppose P rises.

Practice Problem 1 Answers A. people will want to buy the same amount of g&s. What happens to money demand? If Y is unchanged. . An increase in P causes an increase in money demand. other things equal. Suppose P rises. Since P is higher. they will need more money to do so. but Y and r are unchanged.

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

How the Interest-Rate Effect Works A fall in P reduces money demand. 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. which lowers r. .

A higher price level – Raises money demand 2. Monetary Policy Influences Aggregate Demand 1. Higher money demand – Leads to a higher interest rate 3. A higher interest rate – Reduces the quantity of goods and services demanded 10 .

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. . The Effects of Reducing the Money Supply The Fed can raise r by reducing the money supply.

. The Effects of Increasing the Money Supply The Fed can lower r by increasing the money supply. level MS1 MS2 r1 P r2 AD2 MD AD1 0 Quantity 0 Y1 Y2 Quantity of output of money A decrease in r increases the quantity of g&s demanded. (a) The Money Market Price (b) The Aggregate-Demand Curve Interest rate Money supply.

causing oil prices to soar. C.determine the short-run effects on output . Practice Problem #2 Monetary policy For each of the events below. B. Congress tries to balance the budget by cutting gov’t spending. . War breaks out in the Middle East. .determine how the Fed should adjust the money supply and interest rates to stabilize output A. A stock market boom increases household wealth.

. Congress tries to balance the budget by cutting gov’t spending. Practice Problem #2 Answers A. This event would reduce AD & output. the Fed should increase MS and reduce r to increase AD. To offset this event.

To offset this event. . This event would increase AD. raising output above its natural rate. Practice Problem #2 Answers B. the Fed should reduce MS and increase r to reduce AD. A stock market boom increases household wealth.

the Fed should increase MS and reduce r to increase AD. 16 . causing output to fall. War breaks out in the Middle East. Practice Problem #2 Answers C. This event would reduce AS. causing oil prices to soar. To offset this event.

Fiscal Policy and Aggregate Demand • Fiscal policy: the setting of the level of gov’t spending and taxation by gov’t policymakers • Expansionary fiscal policy –an increase in G and/or decrease in T (taxes) –shifts AD right • Contractionary fiscal policy – a decrease in G and/or increase in T – shifts AD left .

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. 1. The Multiplier Effect Multiplier effect: the additional shifts in AD that result when fiscal policy increases income and thereby increases consumer spending • If the govt buys \$20b of planes from Boeing. .

which shifts AD Y1 Y2 Y3 Y further to the right. 1. The Multiplier Effect A \$20b increase in P G initially shifts AD to the right by AD2 AD3 AD1 \$20b. . P1 The increase in Y \$20 billion causes C to rise.

Marginal Propensity to Consume • How big is the multiplier effect? • Marginal propensity to consume (MPC): the fraction of extra income that households consume rather than save • if MPC = 0.8 and income rises \$100. • Marginal propensity to save (MPS): the fraction of extra income that households save rather than consume . C rises \$80.

.75 multiplier = 4 if MPC = 0.9 multiplier = 10 A bigger MPC means 1 Y = changes in Y cause 1 – MPC bigger changes in C. A Formula for the Multiplier The size of the multiplier depends on MPC. if MPC = 0.5 multiplier = 2 if MPC = 0. The multiplier which in turn cause more changes in Y.

which further reduces AD and income. –Initially. . –The fall in Y causes C to fall. • Suppose a recession overseas reduces demand for U. AD falls by \$10b. net exports by \$10b. Other Applications of the Multiplier Effect • The multiplier effect: Each \$1 increase in G can generate more than a \$1 increase in AD • Also true for the other components of GDP.S.

which reduces the net increase in AD. • This is called the crowding-out effect. • A fiscal expansion raises r. The Crowding-Out Effect • Fiscal policy has another effect on AD that works in the opposite direction. which reduces investment. . 2. • So. the size of the AD shift may be smaller than the initial fiscal expansion.

How the Crowding-Out Effect Works A \$20b increase in G initially shifts AD right by \$20b Interest P rate MS AD AD2 r2 AD1 3 P1 r1 MD2 \$20 billion MD1 M Y1 Y3 Y2 Y But higher Y increases MD and r. . which reduces AD.

Changes in Taxes • Tax Cut – increases households’ take-home pay. • Another factor: Do 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. . • The size of the shift is affected by the multiplier and crowding-out effects. – Households respond by spending a portion of this extra income. shifting AD to the right.

Shifting the AD curve rightward by \$200b would end the recession. will Congress need to increase G more or less than this amount? 26 .8 and there is no crowding out. how much should Congress increase G to end the recession? B. If there is crowding out. Practice Problem #3 The economy is in recession. A. If MPC = .

(200/5 =40) . If MPC = .8 and there is no crowding out. Shifting the AD curve rightward by \$200b would end the recession. A.8) = 5 Increase G by \$40b to shift AD 5 x X = \$200b. Practice Problem #3 Answers The economy is in recession. how much should Congress increase G to end the recession? Multiplier = 1/(1 – .

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. Congress should increase G by a larger amount. Practice Problem #3 Answers The economy is in recession. . To offset this. B. Shifting the AD curve rightward by \$200b would end the recession.

so it might increase the quantity of g&s supplied and shift AS to the right. – A cut in the tax rate gives workers incentive to work more. Fiscal Policy and Aggregate Supply • Most economists believe the short-run effects of fiscal policy mainly work through AD. • But fiscal policy might also affect AS.” . • People who believe this effect is large are called “Supply-siders.

Fiscal Policy and Aggregate Supply • Gov’t purchases might affect AS. which increases the quantity of g&s supplied. (more impact on the long run supply) . –Better roads may increase business productivity. • Example: –Gov’t increases spending on roads. shifts AS to the right.

. – booms and recessions abroad – stock market booms and crashes • If policymakers do nothing. these fluctuations are destabilizing to businesses. The Case for Active Stabilization Policy • Keynes: waves of pessimism and optimism among households and firms. workers. e.g. other factors cause fluctuations. consumers. (self- fulfulling prophecy) • Also. leading to shifts in AD and fluctuations in output and employment..

use expansionary monetary or fiscal policy to prevent or reduce a recession. use contractionary policy to prevent or reduce an inflationary boom. . –When GDP rises above its natural rate. The Case for Active Stabilization Policy • Proponents of active stabilization policy believe the gov’t should use policy to reduce these fluctuations: –When GDP falls below its natural rate.

2001: George W Bush pushed for a tax cut that helped the economy recover from a recession that had just begun. Keynesians in the White House 1961: John F Kennedy pushed for a tax cut to stimulate AD. .

– The legislative process can take months or years. 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. The Case Against Active Stabilization Policy • Monetary policy affects economy with a long lag: – Firms make investment plans in advance. • Fiscal policy also works with a long lag: – Changes in G and T require Acts of Congress. • These critics argue that policymakers should focus on long-run goals like economic growth and low inflation.

which stimulates AD. – Gov’t spending on these programs automatically rises. unemployment insurance). . without policymakers having to take any deliberate action • The tax system – In recession. more people apply for public assistance (welfare. which stimulates AD. Automatic Stabilizers • Automatic stabilizers: changes in fiscal policy that stimulate AD when economy goes into recession. taxes fall automatically. • Gov’t spending – In recession.