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The Influence of Monetary and Fiscal Policy on Aggregate Demand Chapter 20 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission.

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Presentation on theme: "The Influence of Monetary and Fiscal Policy on Aggregate Demand Chapter 20 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission."— Presentation transcript:

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2 The Influence of Monetary and Fiscal Policy on Aggregate Demand Chapter 20 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida

3 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Aggregate Demand u Desired spending by households and business firms determines the overall demand for goods and services. u For the U.S. economy, the most important reason for the downward slope of the aggregate-demand curve is the interest-rate effect.

4 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. u When desired spending changes, aggregate demand shifts, causing short- run fluctuations in output and employment. u Monetary and fiscal policy are sometimes used to offset those shifts and stabilize the economy.

5 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Monetary Policy The setting of the money supply by the FOMC to change the interest rate, influence AD, the level of RGDP and the inflation rate.

6 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Money Supply u The money supply is controlled by the Fed through: u Open-market operations u Changing the reserve requirements u Changing the discount rate u The effect of changes in the money supply on interest rates and money demand can be illustrated using the Money Market model

7 Equilibrium in the Money Market... Quantity of Money Interest Rate 0 Money demand Quantity fixed by the Fed Money supply r2r2 M d2d2 r1r1 M d1d1 Equilibrium interest rate Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

8 Money Supply u Because it is fixed by the Fed, the quantity of money supplied does not depend on the interest rate. u The fixed money supply is represented by a vertical supply curve.

9 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Money Demand u Money demand has two features: u Asset demand: People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services. u Asset demand is determined by the current interest rate.

10 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Money Demand u The opportunity cost of holding money is the interest that could be earned on interest-earning assets. u An increase in the interest rate raises the opportunity cost of holding money. u As a result, the quantity of money demanded is reduced.

11 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Money Demand u Transaction demand u Determined by nominal GDP; the more that is produced or the more things cost the more money we need to spend and vice versa. u A change in nominal GDP causes a shift of the money demand curve

12 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Changes in the Money Supply u The Fed can shift the aggregate demand curve when it changes monetary policy. u An increase in the money supply shifts the money supply curve to the right. u Without a change in the money demand curve, the interest rate falls. u Falling interest rates increase the quantity of goods and services demanded.

13 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. MONETARY POLICY, REAL GDP AND THE PRICE LEVEL Cause-Effect Chain Money supply impacts interest rates Interest rates affect investment Investment is a component of AD Equilibrium GDP is changed

14 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Real domestic output, GDP DmDm Investment Demand Real rate of interest, i Quantity of money demanded and supplied Amount of investment, I MONETARY POLICY AND EQUILIBRIUM GDP S m1 AS AD 1 P1P S m2 AD 2 P2P2 Money Supply Increases Interest Rate Decreases Investment Increases AD & GDP Increases with slight inflation If the money supply increases to stimulate the economy... Price level

15 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. AD 1 Price level Real domestic output, GDP DmDm Investment Demand Nominal rate of interest, i Quantity of money demanded and supplied Amount of investment, I MONETARY POLICY AND EQUILIBRIUM GDP S m2 AS S m1 AD2AD2 P2P2 Less Money Supply Higher Interest Rates Less Investment Lower AD & GDP with some unemployment P1P1 If the money supply decreases

16 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Role of Interest-Rate Targets in Fed Policy u Monetary policy can be described either in terms of the money supply or in terms of the interest rate. u Changes in monetary policy can be viewed either in terms of a changing target for the interest rate or in terms of a change in the money supply. u A target for the federal funds rate affects the money market equilibrium, which influences aggregate demand.

17 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How Fiscal Policy Influences Aggregate Demand u Fiscal policy refers to the governments choices regarding the overall level of government purchases or taxes. u Fiscal policy influences saving, investment, and growth in the long run. u In the short run, fiscal policy primarily affects the aggregate demand.

18 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Changes in Government Purchases u When policymakers change the money supply or taxes, the effect on aggregate demand is indirect – through the spending decisions of firms or households. u When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly.

19 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Changes in Government Purchases u There are two macroeconomic effects from the change in government purchases: u The multiplier effect u The crowding-out effect

20 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Multiplier Effect u Government purchases are said to have a multiplier effect on aggregate demand. u Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.

21 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Multiplier Effect... Aggregate demand, AD 1 Quantity of Output 0 Price Level AD 2 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion… $20 billion AD 3 2. …but the multiplier effect can amplify the shift in aggregate demand.

22 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Formula for the Spending Multiplier u The formula for the multiplier is: Multiplier = 1/(1 - MPC) u An important number in this formula is the marginal propensity to consume (MPC). u It is the fraction of extra income that a household consumes rather than saves.

23 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Formula for the Spending Multiplier u If the MPC is 3/4, then the multiplier will be: Multiplier = 1/(1 - 3/4) = 4 u In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

24 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Crowding-Out Effect u Fiscal policy may not affect the economy as strongly as predicted by the multiplier. u An increase in government purchases causes the interest rate to rise. u A higher interest rate reduces investment spending.

25 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Crowding-Out Effect u This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. u The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

26 AD 3 4. …which in turn partly offsets the initial increase in aggregate demand. The Crowding-Out Effect... Aggregate demand, AD 1 (b) The Shift in Aggregate Demand Quantity of Output 0 Price Level (a) The Money Market Quantity of Money Quantity fixed by the Fed 0 r1r1 Money demand, MD 1 Money supply Interest Rate 1. When an increase in government purchases increases aggregate demand… AD 2 $20 billion 3. …which increases the equilibrium interest rate… r2r2 MD 2 2. …the increase in spending increases money demand… Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

27 The Crowding-Out Effect When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.

28 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Changes in Taxes u When the government cuts personal income taxes, it increases households take-home pay. u Households save some of this additional income. u Households also spend some of it on consumer goods. u Increased household spending shifts the aggregate-demand curve to the right.

29 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Changes in Taxes u The size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding-out effects. u It is also determined by the households perceptions about the permanency of the tax change.

30 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Using Policy to Stabilize the Economy Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946.

31 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Case for Active Stabilization Policy The Employment Act has two implications: u The government should avoid being the cause of economic fluctuations. u The government should respond to changes in the private economy in order to stabilize aggregate demand.

32 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Case Against Active Stabilization Policy u Some economists argue that monetary and fiscal policy destabilizes the economy. u Monetary and fiscal policy affect the economy with a substantial lag. u They suggest the economy should be left to deal with the short-run fluctuations on its own.

33 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Automatic Stabilizers u Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. u Automatic stabilizers include the tax system and some forms of government spending.

34 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Keynes proposed the theory of liquidity preference to explain determinants of the interest rate. u According to this theory, the interest rate adjusts to balance the supply and demand for money.

35 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u An increase in the price level raises money demand and increases the interest rate. u A higher interest rate reduces investment and, thereby, the quantity of goods and services demanded. u The downward-sloping aggregate-demand curve expresses this negative relationship between the price-level and the quantity demanded.

36 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Policymakers can influence aggregate demand with monetary policy. u An increase in the money supply will ultimately lead to the aggregate-demand curve shifting to the right. u A decrease in the money supply will ultimately lead to the aggregate-demand curve shifting to the left.

37 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Policymakers can influence aggregate demand with fiscal policy. u An increase in government purchases or a cut in taxes shifts the aggregate-demand curve to the right. u A decrease in government purchases or an increase in taxes shifts the aggregate- demand curve to the left.

38 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u When the government alters spending or taxes, the resulting shift in aggregate demand can be larger or smaller than the fiscal change. u The multiplier effect tends to amplify the effects of fiscal policy on aggregate demand. u The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

39 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Because monetary and fiscal policy can influence aggregate demand, the government sometimes uses these policy instruments in an attempt to stabilize the economy. u Economists disagree about how active the government should be in this effort. u Policy advocates say that if the government does not respond the result will be undesirable fluctuations. u Critics argue that attempts at stabilization often turn out destabilizing.

40 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Graphical Review

41 Equilibrium in the Money Market... Quantity of Money Interest Rate 0 Money demand Quantity fixed by the Fed Money supply r2r2 M d2d2 r1r1 M d1d1 Equilibrium interest rate Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

42 The Money Market and the Slope of the Aggregate Demand Curve... Aggregate demand (b) The Aggregate Demand Curve Quantity of Output 0 Price Level (a) The Money Market Quantity of Money Quantity fixed by the Fed 0 r1r1 Money supply Interest Rate Money demand at price level P 1, MD 1 Y1Y1 P1P1 Money demand at price level P 2, MD 2 2. …increases the demand for money… 1. An increase in the price level… P2P2 3. …which increases the equilibrium equilibrium rate… r2r2 4. …which in turn reduces the quantity of goods and services demanded. Y2Y2

43 A Monetary Injection When the Fed increases the money supply… MS 2 Y1Y1 P Quantity of Output 0 Price Level Aggregate demand, AD 1 (a) The Money Market Quantity of Money 0 Money supply, MS 1 r1r1 Interest Rate (b) The Aggregate-Demand Curve r2r2 2. …the equilibrium interest rate falls… Y2Y2 AD 2 3. …which increases the quantity of goods and services demanded at a given price level. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

44 The Multiplier Effect... Aggregate demand, AD 1 Quantity of Output 0 Price Level AD 2 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion… $20 billion AD 3 2. …but the multiplier effect can amplify the shift in aggregate demand.

45 The Crowding-Out Effect... AD 3 4. …which in turn partly offsets the initial increase in aggregate demand. Aggregate demand, AD 1 (b) The Shift in Aggregate Demand Quantity of Output 0 Price Level (a) The Money Market Quantity of Money Quantity fixed by the Fed 0 r1r1 Money demand, MD 1 Money supply Interest Rate 1. When an increase in government purchases increases aggregate demand… AD 2 $20 billion 3. …which increases the equilibrium interest rate… r2r2 MD 2 2. …the increase in spending increases money demand… Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.


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