ECON6098

Business Economics
Week 9

Government Economic Policy and the

Effect on Business
 Outline

 Monetary Policy
 Fiscal Policy
 How Monetary Policy Influences
Aggregate Demand
 How Fiscal Policy Influences
Aggregate Demand
MONETARY POLICY
 Definition

 monetary policy : the set of actions taken by the central

bank in order to affect the money supply
 The Classical Quantity
Theory Of Money

MV = PY
where,
• M = the money stock,
• V = velocity of circulation,
• P = price level and
• Y = level of national income.
 The Central Bank’s Tools of
Monetary Control

 Open-Market Operations
 The Refinancing Rate
 Reserve Requirements
FISCAL POLICY
 Fiscal Policy

 Fiscal policy influencing the level of economic activity

through manipulation of government income and
expenditure
 Fiscal policy refers to the use of government spending
and tax policies to influence economic conditions.
 Fiscal policy is largely based on ideas from John Maynard
Keynes, who argued governments could stabilize
the business cycle and regulate economic output.
 Expansionary And
Contractionary Fiscal Policies

 During a recession, the government 

may employ expansionary fiscal policy by lowering tax
rates to increase aggregate demand and fuel economic
growth.
 In the face of mounting inflation and other expansionary
symptoms, a government may
pursue contractionary fiscal policy
Deflationary and
Inflationary gap
 Multiplier effect

 multiplier effect : the additional shifts in aggregate

demand that result when expansionary fiscal policy
increases income and thereby increases consumer
spending
 A Formula for the Spending
Multiplier

 marginal propensity to consume (MPC) : the fraction of

extra income that a household spends rather than saves
 marginal propensity to save (MPS) : the fraction of extra
income that a household saves rather than consumes
 MPC + MPS = 1.
 Multiplier = 1/MPS
 Other Applications of the
Multiplier Effect

 Tax Multiplier = -MPC/(1-MPC + MPM)

 Investment multiplier = 1 / (1 – MPC + MPM) 
 Government Multiplier = 1 / (1 – MPC – MPM)
 Import multiplier = 1 / (1 – MPC + MPM)
HOW MONETARY POLICY INFLUENCES
AGGREGATE DEMAND
 Aggregate-demand (AD) curve
slopes downward because of 3
effects

1. The wealth effect

2. The interest-rate effect
3. The exchange-rate effect
 When the price level falls
 quantity of goods and services demanded
increases, with all 3 effects working
 When the price level rises
 quantity of goods and services demanded
decreases, with all 3 effects working
 The Theory of Liquidity
Preference

Interest rate adjusts:

 To bring money supply and money demand into
balance – As in IS-LM analysis (i.e., money supply and
demand underlie the LM curve)
Explains both the nominal interest rate and the real interest
rate since
 Assumption: expected rate of inflation is constant, as
assumed in short run analysis
 Demand and Supply of Money

Money demand
 Money – most liquid asset
 Can be used to buy goods and services
 Interest rate – opportunity cost of holding money
 Money demand curve – downward sloping
 Increase in the interest rate
 Raises the cost of holding money
 Reduces the quantity of money demanded
 Demand and Supply of Money

Money supply
 Controlled by the Central Bank
 Quantity of money supplied
 Fixed by Central Bank policy
 Doesn’t vary with the interest rate
 Central Bank alters the money supply
 By changing the quantity of reserves in the banking
system via the Purchase and sale of government
bonds in open-market operations
 Demand and Supply of Money

Equilibrium in the money market

 Interest rate adjusts to balance the supply and demand
for money
 Equilibrium interest rate
 Quantity of money demanded exactly balances the
quantity of money supplied
Demand and Supply of Money
The Downward Slope of the
Aggregate Demand Curve
Changes in the Money Supply
HOW FISCAL POLICY INFLUENCES
AGGREGATE DEMAND
 Crowding Out Effect

The Crowding-Out Effect : the offset in aggregate demand

that results when expansionary fiscal policy raises the
interest rate and thereby reduces investment spending
Crowding Out Effect
 Changes in taxes

A decrease in personal income taxes

 Households incomes increase
 Multiplier effect
 Aggregate demand increases
 Crowding-out effect
 Aggregate demand decreases
 Efficacy of tax changes on AD also depends on whether
the tax cut is permanent or temporary
 Permanent tax cut - large impact on AD
 Temporary tax cut - small impact on AD
 References

 N. Gregory Mankiw, (2018), Principles Of Economics,

Eighth Edition, Cengage Learning, ISBN 13: 978-1-305-
58512-6, chapter 34
 John Sloman and Elizabeth Jones, (2017), Essential
Economics for Business, Fifth edition, Pearson Education
Ltd, United Kingdom, ISBN : 978-1-292-15131-1, chapter
11
 N. Gregory Mankiw, Mark P. Taylor, Andrew Ashwin,
(2013). Business Economics, 1 Edition, Cengage Learning.
United Kingdom, ISBN: 978-1-4080-6981-3, Chapter 20
Thank You