The Influence of Monetary

and Fiscal Policy on

Aggregate Demand

David Chow
Apr 2020
Introduction: Demand Management
 Keynes: AD is highly unstable
 “animal spirits” of human beings

 “Demand management”
refers to the govt’s Herd Behavior
manipulating the AD
 through monetary
or fiscal policies
Unstable AD

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Monetary Policy (1 of 3)
How does it work?

Consumption
Money Interest Aggregate
Supply rate Demand
Investment

 Policy tools: MS or i
 MS = money supply
 i = interest rate

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Monetary Policy (2 of 3)
 Keynes’ theory of liquidity preference:
 Interest rate adjusts to balance the supply and demand for money
 Simply applying supply & demand to the money market

 Also a theory on
 Money demand, and
 Interest rate determination

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 Monetary Policy (3 of 3)
Eg: An Expansionary Monetary Policy

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Major Interest Rates (1 of 2)
 Discount rate
 The rate at which central bank lends to commercial
banks

 Interbank offered rate

 The rate at which commercial
banks lends to its peers
 Called “Federal Funds Rate” in the US

 Prime (lending) rate

 It is the interest rate charged by banks to the most
creditworthy customers
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 Major Interest Rates (2 of 2)
 US monetary policy can be summarized by the Fed’s interest rate targets
 Recent turning points:
Dates The Fed’s target interest rate (range) Zero Again …
before the change  The Fed made an emergency
2019 Aug 1 2.25-2.50 cut on Mar 16, 2020
2015 Dec 17 0-0.25  The target rate is back to zero
2007 Sep 18 5.25 again (more precisely, 0-0.25%)
2004 June 30 1.00

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A Pitfall: Liquidity Trap
 When nominal interest rate is close to zero, a bigger MS can
hardly lower interest rate
 Can’t stimulate AD either

 Keynes called it a “liquidity trap”

 I.e., People prefer holding cash (liquidity), usually in times of ____

MS Interest rate
Investment

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Monetary Policy Effectiveness
 There’s a time lag of 6 to 9 months
 But fiscal policy has a time lag too …

 Inflation threat

 Other concerns
 Uncertainty of exit (i.e., monetary contraction)
 Distorted interest rate signals to the market
 Liquidity trap, etc

 Still, monetary policy is commonly used for SR stabilization

 OMO enables easy fine-tuning and
 Quick responses to sudden changes (to ease cash-flow problems)
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 OMO QE
OMO vs QE
OMO: Traditional Monetary Policy
QE: Quantitative Easing Zero rate
i>0
- Both are water-pumping (i = 0 to 0.25%)
- but QE is very “innovative” …
Trading
Trading longer-term
short-term govt bonds
govt bonds and private
securities

Targeting
short-term i Targeting
longer-term i

Trading with
banks Trading with
non-banks too
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Fiscal Policy
  Government’s choices regarding
Fiscal Policy govt purchases (G) or taxes (T)
 Mainly affects AD in the SR

How does it work?

G
Government Aggregate Demand
(Treasury)
T Consumption

 Note that
1. Transfer payments can be regarded as a negative tax
2. In the LR, fiscal policy can shift AS by affecting saving,
investment and growth. But our focus here is mainly in the SR

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Shift in AD
 AD shifts when any component of GDP (C, I, G, NX) changes
 How much will AD shift?
 The size of the AD shift
depends on:
1. The multiplier effect, and
2. The crowding out effect

Suppose “blue palm” starts

spending, the “orange guy” will …

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Multiplier Effect (1 of 5)
Consumption Function

C = Co + MPC (Y)

hence C = MPC (Y)

 Assume a constant MPC

 I.e., Consumers spend a

fixed portion of their
additional income

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Multiplier Effect (2 of 5)
 Consumption Function (cont)

 Co = autonomous consumption
1. A minimum amount for survival (level of consumption when Y is zero)
2. Alternatively, Co can be regarded as a function of “non-income”
determinants (eg, expectation, wealth effect, survival needs, etc)

 MPC = marginal propensity to consume

 Typical values of MPC range from 0.70 to 0.90

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Multiplier Effect (3 of 5)
Eg: A Rise in G by $1000 (Assuming MPC = 0.9)
• Suppose Amy is hired as a substitute teacher
• Immediate effect: AD rises by $1000
• AD increases further as …...

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Multiplier Effect (4 of 5)
Eg: A Rise in G (cont)

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Multiplier Effect (5 of 5)
  

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Crowding Out
 Crowding-out may dampen the
multiplier effect
 Crowing out effect
 the offset in YD that results when
expansionary fiscal policy raises the
interest rate,
 thereby reducing investment (and
consumption) spending IMAGINE
Someone
pushing in
 G  MD  i THEN
 I and C  YD Someone
squeezed out

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Combined Effect on AD
 Effect of a higher G
 Multiplier effect: AD shifts to the ____
 Crowding-out effect: AD shifts to the ____

 AD shifts in or out?

 Keynes laughs at the idea of crowding

out, because resources
are unemployed during recessions

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Case Study: Airport Core Programme (ACP)
• ACP is one of the world's more impressive infrastructure projects
• Just 7 years between design inception in 1991 & operation in 1998

• Crowding out
occurs when
resources are
(near) full
employment
• ACP offers a rare
example

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Effect of a Tax Cut
 Modify the consumption function in
the presence of tax:

C = Co + MPC (Y - T), where

 (Y - T) is the disposable income or take-home pay

 T can be negative (transfer payment)

 The effect is weaker for a temporary tax

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The Case for Active Stabilization
 Keynes and his disciples root for
active stabilization because of

 The inherently unstable nature of

the economy due to the “animal
spirits” of human beings, and

 Sticky prices and wages – free

market cannot adjust quickly
enough

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Problems in Active Stabilization
General Problems
 Substantial lags in monetary & fiscal policies
 A policy that comes too late may become a cause rather than a cure
for economic fluctuation

 Imprecise economic forecasting

 Market may handle SR fluctuations better

 Vested interest of government officials

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Problems in Active Stabilization
by Fiscal Policy (1 of 2)
 Multiplier effect minimal when people are
 Inclined to buy imports
 Uncertain about the future
 Expect to pay higher tax (because of greater G now) in the future
 Range of multiplier (in reality): ___ to ___

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Problems in Active Stabilization
by Fiscal Policy (2 of 2)
 Crowding out
 Failure to boost output in the LR
 Deficit to be a burden in the future
 Fear of printing money may cause financial instability
 Opportunity cost of G

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Reading: Sales Tax Hike

Background

 Japan's sales tax hike from

5 to 8% in Apr 2014 is
the first of two rounds
 It is scheduled to rise to Discussion Questions
10% in Oct 2015
1. Why did Japan raise the sales tax rate to
 After a few delays, Japan
10% despite recessionary concerns?
finally raised the sales tax
further to 10% in Oct 2019 2. A higher sales tax is supposed to reduce
consumption. It has happened to Japan
before. Do you expect this to happen this
time? Why or why not?
See Japan delivers long-
delayed consumption tax hike
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Reading: Cash Handouts

COVID-19 and Fiscal Policy

1. Is the cash handout program effective in stimulating consumption?

2. What measures are suggested to reduce the negative impact from
COVID-19?
3. The purpose of these measures is to (a) increase AD, or (b) stop AD
from shrinking further?

See Airline bailouts? Cash handouts? Debate deepens

on inoculating economy against coronavirus

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Reading: Quantitative Easing
Two Opposite Views

1. Suggest reasons why QE is

regarded as an effective policy
2. Suggest reasons why QE is
regarded as an ineffective policy

See “Fed economist: 'No evidence that QE works‘…”

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