Monetary and Fiscal Policies IMBA Macroeconomics IV Jack Wu

Short-Run Economic Fluctuation Economic activity fluctuates from year to year. A recession is a period of declining real incomes, and rising unemployment. A depression is a severe recession. Fluctuations in the economy are often called the business cycle.

Basic Model Two variables are used to develop a model to analyze the short-run fluctuations. The economy’s output of goods and services measured by real GDP. The overall price level measured by the CPI or the GDP deflator. The Basic Model of Aggregate Demand and Aggregate Supply Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

Aggregate Demand and Supply Curves The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

Aggregate Demand and Aggregate Supply Price Level Aggregate supply Aggregate demand Equilibrium output price level Quantity of Output Copyright © 2004 South-Western

Aggregate Demand Curve The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

The Aggregate-Demand Curve... Price Level Aggregate demand P Y 1. A decrease in the price level . . . Y2 P2 Quantity of 2. . . . increases the quantity of goods and services demanded. Output Copyright © 2004 South-Western

Shifts Shifts arising from Consumption Investment Government Purchases Net Exports

Demand Curve Shifts Price Level D2 P1 Y2 Aggregate demand, D1 Y1 Remove bullet in graph – graph needs no additional title??? Aggregate demand, D1 Y1 Quantity of Output

Aggregate Supply Curve In the long run, the aggregate-supply curve is vertical. In the short run, the aggregate-supply curve is upward sloping.

The Long-Run Aggregate-Supply Curve Price Level Long-run aggregate supply P 1. A change in the price level . . . P2 2. . . . does not affect the quantity of goods and services supplied in the long run. Natural rate Quantity of of output Output Copyright © 2004 South-Western

Long-Run Aggregate Supply Curve The Long-Run Aggregate-Supply Curve The long-run aggregate-supply curve is vertical at the natural rate of output. This level of production is also referred to as potential output or full-employment output. Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve. The shifts may be categorized according to the various factors in the classical model that affect output.

Shifts Shifts arising Labor Capital Natural Resources Technological Knowledge

Long-Run Growth and Inflation 2. . . . and growth in the money supply shifts aggregate demand . . . Long-run aggregate supply, LRAS 1980 Y 1990 LRAS Y 2000 LRAS Price Aggregate Demand, AD 2000 Level 1. In the long run, technological progress shifts long-run aggregate supply . . . AD 1990 P 2000 4. . . . and ongoing inflation. P 1990 P 1980 AD 1980 Y 1980 3. . . . leading to growth in output . . . Quantity of Output Copyright © 2004 South-Western

Short-Run Aggregate Supply Curve Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends. In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied. A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

The Short-Run Aggregate-Supply Curve Price Level Short-run aggregate supply Y P 1. A decrease in the price level . . . Y2 P2 2. . . . reduces the quantity of goods and services supplied in the short run. Quantity of Output Copyright © 2004 South-Western

The Long-Run Equilibrium Price Level Long-run aggregate supply Short-run aggregate supply Aggregate demand A Equilibrium price Natural rate of output Quantity of Output Copyright © 2004 South-Western

Two Causes of Economic Fluctuation Shifts in Aggregate Demand In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. In the long run, shifts in aggregate demand affect the overall price level but do not affect output. An Adverse Shift in Aggregate Supply A decrease in one of the determinants of aggregate supply shifts the curve to the left: Output falls below the natural rate of employment. Unemployment rises. The price level rises

A Contraction in Aggregate Demand 2. . . . causes output to fall in the short run . . . Price Level Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD AS2 AD2 3. . . . but over time, the short-run aggregate-supply curve shifts . . . A P Y B P2 Y2 1. A decrease in aggregate demand . . . C P3 4. . . . and output returns to its natural rate. Quantity of Output Copyright © 2004 South-Western

An Adverse Shift in Aggregate Supply 1. An adverse shift in the short- run aggregate-supply curve . . . Price Level Long-run Short-run aggregate supply, AS AS2 aggregate supply Aggregate demand B Y2 P2 Y A P 3. . . . and the price level to rise. Quantity of 2. . . . causes output to fall . . . Output Copyright © 2004 South-Western

Stagflation Stagflation Adverse shifts in aggregate supply cause stagflation—a period of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

Policy Responses to Recession Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using monetary and fiscal policy.

Accommodating an Adverse Shift in Aggregate Supply 1. When short-run aggregate supply falls . . . Price Level Long-run Short-run aggregate supply, AS AS2 aggregate AD2 supply C P3 2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . 3. . . . which causes the price level to rise further . . . P2 A P 4. . . . but keeps output at its natural rate. Aggregate demand, AD Natural rate Quantity of of output Output Copyright © 2004 South-Western

Equilibrium in the Money Market Interest Rate Money supply Money demand M d r1 Equilibrium interest rate r2 M2 d Quantity fixed Quantity of by the Fed Money Copyright © 2004 South-Western

Price and Quantity Demanded The price level is one determinant of the quantity of money demanded. A higher price level increases the quantity of money demanded for any given interest rate. Higher money demand leads to a higher interest rate. The quantity of goods and services demanded falls. The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded.

The Money Market and the Slope of the Aggregate-Demand Curve (a) The Money Market (b) The Aggregate-Demand Curve Interest Money Price Rate supply Level Money demand at price level P2 , MD2 2. . . . increases the demand for money . . . r2 Money demand at price level P , MD P2 Y2 3. . . . which increases the equilibrium interest rate . . . 1. An increase in the price level . . . r Y P Aggregate demand Quantity fixed Quantity Quantity 4. . . . which in turn reduces the quantity of goods and services demanded. by the Fed of Money of Output Copyright © 2004 South-Western

Fed’s Monetary Injection The Fed can shift the aggregate demand curve when it changes monetary policy. An increase in the money supply shifts the money supply curve to the right. Without a change in the money demand curve, the interest rate falls. Falling interest rates increase the quantity of goods and services demanded.

A Monetary Injection (a) The Money Market (b) The Aggregate-Demand Curve Interest Price Rate Money supply, MS MS2 Level AD2 Money demand at price level P 1. When the Fed increases the money supply . . . r Y P 2. . . . the equilibrium interest rate falls . . . r2 Aggregate demand, A D Quantity Y Quantity 3. . . . which increases the quantity of goods and services demanded at a given price level. of Money of Output Copyright © 2004 South-Western

Impacts of Monetary Policy on Aggregate Demand When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the right. When the Fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the left.

Forms of Monetary Policy Monetary policy can be described either in terms of the money supply or in terms of the interest rate. 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. A target for the federal funds rate affects the money market equilibrium, which influences aggregate demand.

Fiscal Policy Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes. Fiscal policy influences saving, investment, and growth in the long run. In the short run, fiscal policy primarily affects the aggregate demand.

Fiscal Policy: continued When policymakers change the money supply or taxes, the effect on aggregate demand is indirect—through the spending decisions of firms or households. When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly.

Two Macroeconomic Effects There are two macroeconomic effects from the change in government purchases: The multiplier effect The crowding-out effect

The Multiplier Effect Price Level AD3 AD2 2. . . . but the multiplier effect can amplify the shift in aggregate demand. Aggregate demand, AD1 $20 billion 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion . . . Quantity of Output Copyright © 2004 South-Western

The Crowding-Out Effect (a) The Money Market (b) The Shift in Aggregate Demand Interest Price 4. . . . which in turn partly offsets the initial increase in aggregate demand. Rate Money AD2 Level supply AD3 2. . . . the increase in spending increases money demand . . . $20 billion M D2 1. When an increase in government purchases increases aggregate demand . . . r2 3. . . . which increases the equilibrium interest rate . . . r Aggregate demand, AD1 Money demand, MD Quantity fixed Quantity Quantity by the Fed of Money of Output Copyright © 2004 South-Western