1. Copyright © 2006 Pearson Education Canada Fiscal and Monetary Interactions 29 CHAPTER

2. Copyright © 2006 Pearson Education Canada Objectives After studying this chapter, you will able to  Explain macroeconomic equilibrium  Explain how fiscal policy influences real GDP and the price level  Explain monetary policy influences real GDP and the price level  Explain the Keynesian–monetarist debate  Explain the effects of fiscal and monetary policies influences at full employment  Explain how fiscal and monetary policies might be coordinated or in conflict

3. Copyright © 2006 Pearson Education Canada Sparks Fly in Ottawa Does it matter if fiscal policy and monetary policy come into conflict  creating sparks on Sparks Street, the home of the Bank of Canada? If a recession is looming on the horizon, is an interest rate cut by the Bank of Canada just as good as a tax cut by Parliament? If the economy is overheating, is an interest rate hike by the Bank of Canada just as good as a tax increase by Parliament?

4. Copyright © 2006 Pearson Education Canada Macroeconomic Equilibrium Two Markets in Short-Run Equilibrium Aggregate demand and short-run aggregate supply determine real GDP and the price level. The demand for and supply of real money determine the interest rate. Aggregate demand and the money market are linked.

5. Copyright © 2006 Pearson Education Canada Macroeconomic Equilibrium The higher are real GDP and the price level, the greater is demand for money and the higher is the interest rate. But the higher is the interest rate, the smaller is aggregate demand. Only one level of aggregate demand and one interest rate are consistent with each other in macroeconomic equilibrium.

6. Copyright © 2006 Pearson Education Canada Macroeconomic Equilibrium Simultaneous Equilibrium In Fig. 29.1(a) aggregate demand and short-run aggregate supply curve determine real GDP and the price level.

7. Copyright © 2006 Pearson Education Canada Macroeconomic Equilibrium Some components of the expenditures included in aggregate demand are influenced by the interest rate. And the interest rate is determined by equilibrium in the money market.

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9. Macroeconomic Equilibrium In Fig. 29.1(b) the demand for money and the supply of money determine the interest rate. The MD curve depends on the level of real GDP.

10. Copyright © 2006 Pearson Education Canada Macroeconomic Equilibrium The MD curve here is that for equilibrium real GDP in Fig. 29.1(a). The MS curve depends on the price level. The MS curve here is that for the equilibrium price level in Fig. 29.1(a).

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12. Copyright © 2006 Pearson Education Canada Macroeconomic Equilibrium In Fig. 29.1(c), the IE curve determines the level of interest-sensitive expenditure at the equilibrium interest rate. This equilibrium is the level of this expenditure that lies behind the AD curve in Fig. 29.1(a).

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14. Copyright © 2006 Pearson Education Canada Macroeconomic Equilibrium Check the Equilibrium The AS–AD equilibrium in Fig. 29.1(a), the money market equilibrium in Fig. 29.1(b), and interest-sensitive expenditure in Fig. 29.1(c) are consistent with each other and are the only equilibrium. If AD were less than in Fig. 29.1(a), real GDP would be less, the demand for money would be less, the interest rate would be lower, interest-sensitive expenditure would be higher, and AD would be greater. There is a contradiction. AD cannot be less than in Fig. 29.1(a).

15. Copyright © 2006 Pearson Education Canada Macroeconomic Equilibrium If AD were greater than in Fig. 29.1(a), real GDP would be more, the demand for money would be more, the interest rate would be higher, interest-sensitive expenditure would be lower, and AD would be smaller. Again, there is a contradiction. AD cannot be greater than in Fig. 29.1(a). Only one level of aggregate demand delivers the same money market equilibrium and AS–AD equilibrium.

16. Copyright © 2006 Pearson Education Canada Fiscal Policy in the Short Run First Round Effects of Fiscal Policy A fiscal policy that increases aggregate demand is called an expansionary fiscal policy. Figure 29.2 shows the first round effect of an expansionary fiscal policy.

17. Copyright © 2006 Pearson Education Canada Fiscal Policy in the Short Run The first round effect is an increase in aggregate demand. The AD curve shifts rightward (with a multiplier). Real GDP now starts to increase and the price level starts to rise.

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19. Fiscal Policy in the Short Run Second Round Effects of Fiscal Policy Through the second round, real GDP increases and the price level rises until a new macroeconomic equilibrium is reached. To keep track of the second round effects, split them into two parts: one that results from the increasing real GDP, and the other that results from the rising price level.

20. Copyright © 2006 Pearson Education Canada Fiscal Policy in the Short Run The increasing real GDP increases the demand for money. In Fig. 29.3(b), the demand for money curve shifts rightward. The interest rate rises.

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22. Fiscal Policy in the Short Run In Fig. 29.3(c), interest- sensitive expenditure decreases.

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24. Fiscal Policy in the Short Run In Fig. 29.3(a), aggregate demand decreases and the AD curve shifts leftward.

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26. Fiscal Policy in the Short Run The rising price level decreases the quantity of real money. In Fig. 29.3(b), the MS curve shifts leftward. The interest rate rises further.

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28. Fiscal Policy in the Short Run In Fig. 29.3(c), interest- sensitive expenditure decreases further.

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30. Fiscal Policy in the Short Run And in Fig. 29.3(a), the rising price level brings a gradual movement up along the short-run aggregate supply curve.

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32. Fiscal Policy in the Short Run Figure 29.4 summarizes the effects of an expansionary fiscal policy.

33. Copyright © 2006 Pearson Education Canada Fiscal Policy in the Short Run Other Fiscal Policies The adjustments just described can follow:  An increase in government expenditures  An increase in transfer payments  A decrease in taxes The only difference is the magnitude of the multiplier that determines the size of the shift of the AD curve.

34. Copyright © 2006 Pearson Education Canada Fiscal Policy in the Short Run Crowding Out and Crowding In Crowding out is the tendency for expansionary fiscal policy to decrease investment. Crowding out occurs because an expansionary fiscal policy increases the interest rate. Partial crowding out—the normal case—occurs when the decrease in investment is less than the increase in government expenditures. Complete crowding out occurs if the decrease in investment equals the initial increase in government expenditures.

35. Copyright © 2006 Pearson Education Canada Fiscal Policy in the Short Run Crowding in is the tendency for expansionary fiscal policy to increase investment. Crowding in might occur because:  An expansionary fiscal policy might create expectations of a more speedy recovery and bring an increase in expected profits.  Government expenditures might be productive and lead to more profitable business opportunities.  An expansionary fiscal policy takes the form of a cut in taxes on business profits, firms’ after-tax profits increase and investment might increase.

36. Copyright © 2006 Pearson Education Canada Fiscal Policy in the Short Run The Exchange Rate and International Crowding Out International crowding out is the tendency for an expansionary fiscal policy to decrease net exports. International crowding out occurs because an expansionary fiscal policy raises the exchange rate, which decreases net exports.

37. Copyright © 2006 Pearson Education Canada Monetary Policy in the Short Run Figure 29.5 illustrates the first round effects of an expansionary monetary policy. In Fig. 29.5(a), the Bank of Canada increases the money supply. The MS curve shifts rightward and the interest rate falls.

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39. Monetary Policy in the Short Run In Fig. 29.5(b), the lower interest rate increases interest-sensitive expenditure.

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41. Monetary Policy in the Short Run In Fig. 29.5(c), the increase in interest- sensitive expenditure increases aggregate demand. The AD curve shifts rightward. The increase in aggregate demand sets off a multiplier process in which real GDP and the price level begin to increase.

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43. Monetary Policy in the Short Run Second Round Effects As in the case of fiscal policy, it is best to break the second round into two parts: the consequence of increasing real GDP, and the consequence of the rising price level.

44. Copyright © 2006 Pearson Education Canada Monetary Policy in the Short Run In Figure 29.6(a) the increasing real GDP increases the demand for money. The interest rate rises.

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46. Monetary Policy in the Short Run In Figure 29.6(b), the rise in the interest rate decreases interest- sensitive expenditure.

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48. Monetary Policy in the Short Run In Figure 29.6(c), the decrease in interest- sensitive expenditure decreases aggregate demand.

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50. Monetary Policy in the Short Run The rising price level decreases the quantity of real money. In Fig. 29.6(a), the MS curve shifts leftward. The interest rate rises further.

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52. Monetary Policy in the Short Run In Fig. 29.6(b), interest- sensitive expenditure decreases further.

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54. Monetary Policy in the Short Run In Fig. 29.6(c), the rising price level brings a gradual movement up along the short-run aggregate supply curve.

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56. Monetary Policy in the Short Run Figure 29.7 summarizes the effects of an expansionary monetary policy.

57. Copyright © 2006 Pearson Education Canada Monetary Policy in the Short Run Money and the Exchange Rate An increase in the money supply  lowers the interest rate,  depreciates the dollar, and  increases net exports.

58. Copyright © 2006 Pearson Education Canada Relative Effectiveness of Policies Effectiveness of Fiscal Policy The effectiveness of fiscal policy depends on the strength of the crowding-out effect. Fiscal policy is most powerful if no crowding out occurs. Fiscal policy is impotent if there is complete crowding out. The strength of the crowding-out effect depends on 1.The responsiveness of expenditure to the interest rate 2.The responsiveness of the quantity of money demanded to the interest rate

59. Copyright © 2006 Pearson Education Canada Relative Effectiveness of Policies Other things remaining the same, fiscal policy is more effective: 1. The smaller the responsiveness of expenditure to the interest rate 2. The greater the responsiveness of the quantity of money demanded to the interest rate

60. Copyright © 2006 Pearson Education Canada Relative Effectiveness of Policies Effectiveness of Monetary Policy The effectiveness of monetary policy depends on the same two factors that influence the effectiveness of fiscal policy: 1. The responsiveness of the quantity of money demanded to the interest rate 2. The responsiveness of expenditure to the interest rate

61. Copyright © 2006 Pearson Education Canada Relative Effectiveness of Policies Other things remaining the same, monetary policy is more effective: 1.The larger the initial change in the interest rate 2.The greater the responsiveness of expenditure to the interest rate

62. Copyright © 2006 Pearson Education Canada Relative Effectiveness of Policies Keynesian-Monetarist Controversy The Keynesian–monetarist controversy was a dispute in macroeconomics between two broad groups of economists. A Keynesian is a macroeconomist who regards the economy as being inherently unstable and as requiring active government intervention to achieve stability. Keynesian views are based on the theories of John Maynard Keynes, published in Keynes’ General Theory.

63. Copyright © 2006 Pearson Education Canada Relative Effectiveness of Policies Traditionally they assigned a low degree of importance to monetary policy and a high degree of importance to fiscal policy. Modern Keynesians assign a high degree of importance to both types of policy.

64. Copyright © 2006 Pearson Education Canada Relative Effectiveness of Policies A monetarist is a macroeconomist who believes that most macroeconomic fluctuations are caused by fluctuations in the quantity of money. Monetarists regard the economy as being inherently stable and as requiring no active government intervention. Monetarist views about the functioning of the economy are based on theories most forcefully set forth by Milton Friedman.

65. Copyright © 2006 Pearson Education Canada Relative Effectiveness of Policies Monetarists traditionally have assigned a low degree of importance to fiscal policy. Modern monetarists, like modern Keynesians, assign a high degree of importance to both types of policy.

66. Copyright © 2006 Pearson Education Canada Relative Effectiveness of Policies The nature of the Keynesian–monetarist debate has changed over the years. During the 1950s and 1960s, it was a debate about the relative effectiveness of fiscal policy and monetary policy in changing aggregate demand. Extreme Keynesians said that only fiscal policy could work. Extreme monetarists said that only monetary policy could work.

67. Copyright © 2006 Pearson Education Canada Relative Effectiveness of Policies Sorting Out the Competing Claims The dispute between Keynesians and monetarists was a disagreement about the magnitudes of two economic parameters: 1.The responsiveness of expenditure to the interest rate 2.The responsiveness of the demand for real money to the interest rate Neither extreme position is supported by the evidence.

68. Copyright © 2006 Pearson Education Canada Relative Effectiveness of Policies Interest Rate and Exchange Rate Effectiveness Expansionary fiscal policy raises the interest rate and the exchange rate. Expansionary monetary policy lowers the interest rate and the exchange rate. Combined fiscal and monetary expansion has a small effect on the interest rate and the exchange rate.

69. Copyright © 2006 Pearson Education Canada Policy Actions at Full Employment Expansionary Fiscal Policy at Full Employment Figure 29.8 illustrates the long-run effects of an expansionary fiscal policy at full employment. An increase in aggregate demand creates an inflationary gap.

70. Copyright © 2006 Pearson Education Canada Policy Actions at Full Employment The money wage rate rises and decreases short- run aggregate supply. The SAS curve starts moving leftward. Real GDP returns to potential GDP and the price level rises.

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72. Policy Actions at Full Employment Crowding Out at Full Employment At full employment, an increase in government expenditures completely crowds out private expenditure or creates an international (net exports) deficit, or results in a combination of the two.

73. Copyright © 2006 Pearson Education Canada Policy Actions at Full Employment Long-Run Neutrality Long-run neutrality is the proposition is that in the long run a change in the quantity of money changes the price level and leaves all real variables unchanged.

74. Copyright © 2006 Pearson Education Canada Policy Coordination and Conflict Policy coordination occurs when the government and the Bank of Canada work together to achieve a common set of goals. Policy conflict occurs when the government and the Bank of Canada pursue different goals and the actions of one make it harder (perhaps impossible) for the other to achieve its goals.

75. Copyright © 2006 Pearson Education Canada Policy Coordination and Conflict Policy Coordination Policy coordination takes advantage of the fact that either fiscal policy or monetary policy can be used to increase aggregate demand but each has different effects on other variables.

76. Copyright © 2006 Pearson Education Canada Policy Coordination and Conflict An expansionary fiscal policy raises the interest rate and the exchange rate and decreases investment and net exports. An expansionary monetary policy lowers the interest rate and the exchange rate and increases investment and net exports. By coordinating fiscal policy and monetary policy the desired level of aggregate demand and investment and net exports can be achieved.

77. Copyright © 2006 Pearson Education Canada Policy Coordination and Conflict Policy Conflict Governments (both federal and provincial) pay a lot of attention to employment and production over a short time horizon. They look for policies that make their re-election chances high. The Bank of Canada pays a lot of attention to price level stability and has a long time horizon. It doesn’t have an election to worry about. So a situation might arise in which the government wants the Bank to pursue an expansionary monetary policy but the Bank wants to keep its foot on the monetary brake.

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