Principles of Macroeconomics: Ch. 20 Second Canadian Edition Chapter 20 The Influence of Monetary and Fiscal Policy on Aggregate Demand © 2002 by Nelson, a division of Thomson Canada Limited

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Overview  The theory of liquidity preference.  The supply and demand for money.  How fiscal policy affects aggregate demand.  The economy in the long-run and short-run.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Aggregate Demand (AD)  Many factors influence AD, including desired spending by households and business firms. When desired spending changes, shifts in the AD cause short-run fluctuations in output and employment.  Monetary and Fiscal policy are used to stabilize the economy during these fluctuations.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition How Monetary Policy Influences Aggregate Demand  The Aggregate Demand curve is downward sloping due to three effects: – Pigou’s Wealth Effect – Keynes’s Interest-Rate Effect – Real Exchange-Rate Effect  Of these three effects, the Keynes’s Interest-Rate Effect is most important.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Theory of Liquidity Preference: Keynes’s theory: The development of interest rates  The Liquidity Preference Theory of interest rates states that “...market rates of interest adjust to balance the supply and demand for money.”

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Theory of Liquidity Preference: Keynes’s theory: The development of interest rates  Summary: An increase in the price level causes an increase in the demand for money, which leads to higher interest rates, which leads to reduced total spending (i.e. AD).

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Overview The theory of liquidity preference.  The supply and demand for money.  How fiscal policy affects aggregate demand.  The economy in the long-run and short-run.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Theory of Liquidity Preference: The Supply and Demand for Money  The Money Supply is controlled by the B of C, which alters the money supply in three ways: – Open-Market Operations – Changing the Bank Rate – Buying and selling Canadian dollars in the market for foreign-currency exchange  The quantity of money supplied in the economy is fixed at whatever level the B of C decides to set it.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Theory of Liquidity Preference: The Supply and Demand for Money  Because the money supply is fixed by the B of C it does not depend on the interest rate.  The fixed money supply is represented by a vertical supply curve.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Money Market Interest Rate Quantity of Money Money Supply Q Fixed

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Theory of Liquidity Preference: The Supply and Demand for Money  By using the Open-Market Operations the B of C can shift the vertical money supply curve left or right.  If the B of C buys government bonds: – Bank reserves increase and the money supply increases.  If the B of C sells government bonds: – Bank reserves decrease and the money supply declines.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Money Market Interest Rate Quantity of Money Money Supply Q Fixed If the B of C buys government bonds, money supply increases.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Money Market Interest Rate Quantity of Money Money Supply Q Fixed If the B of C sells government bonds, money supply decreases.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Theory of Liquidity Preference: The Supply and Demand for Money  The Money Demand is determined by several factors. However, the most important is the interest rate.  “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.” (i.e. a desire of liquidity)

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Theory of Liquidity Preference: The Supply and Demand for Money  The primary opportunity cost of having the convenience of holding money is the interest income that one gives up when one holds cash or chequing account balances.  An increase in the interest rate raises the cost of holding money and thus reduces the quantity of money balances people wish to hold.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Money Market Interest Rate Quantity of Money Money Demand I0I0 Q0Q0

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Money Market Interest Rate Quantity of Money Money Demand I0I0 I1I1 Q0Q0

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Money Market Interest Rate Quantity of Money Money Demand I0I0 I1I1 Q1Q1 Q0Q0

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Equilibrium in the Money Market  By the Theory of Liquidity Preference: – The interest rate adjusts to balance the supply and demand for money. – There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded exactly equals the quantity of money supplied.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Equilibrium in the Money Market Interest Rate Quantity of Money Money Demand Money Supply Q Fixed

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Equilibrium in the Money Market Interest Rate Quantity of Money Money Demand Money Supply Q Fixed IEIE

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Equilibrium in the Money Market Interest Rate Quantity of Money Money Demand Money Supply Q Fixed IEIE Money Supply and Money Demand are equal at the equilibrium interest rate.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Theory of Liquidity Preference and the Aggregate Demand Curve  The general price level of all goods and services in the economy influences the money demand and interest rates: – A higher price level raises money demand (i.e. a shift in the money demand curve.) – Higher money demand leads to a higher interest rate. – Higher interest rates reduces the quantity of goods and services demanded (AD).

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Theory of Liquidity Preference and the Aggregate Demand Curve  As interest rates increase, the cost of borrowing and the return to saving is greater. Fewer households and firms borrow money, leading to a decrease in spending.  An increase in the price level causes the real exchange rate to increase and net exports to fall.  The end result is a negative relationship between the price level and the AD.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Changes in the Money Supply  The B of C has control over shifts in the aggregate demand when it changes monetary policy. Recall: An increase in the money supply (i.e. buying bonds) will... …shift the Money Supply to the right … without a change in the Money Demand the interest rate will fall, thus … inducing people to hold the additional money the B of C has created.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Changes in Money Supply Interest Rate Quantity of Money Money Demand MS 0 Q Fixed0 I E0

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Changes in Money Supply Interest Rate Quantity of Money Money Demand MS 0 Q Fixed0 I E0 MS 1

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Changes in Money Supply Interest Rate Quantity of Money Money Demand MS 0 Q Fixed0 I E0 MS 1

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Changes in Money Supply Interest Rate Quantity of Money Money Demand MS 0 Q Fixed0 I E0 I E1 Q Fixed1 MS 1

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Monetary Policy in the Closed Economy  A monetary injection by the B of C causes interest rates to fall, leading to a stimulative effect on residential and firm investment, and increasing output.  The increase in output requires that people hold more money. This raises the demand curve for money and causes a partial reversal in the interest rate.  As a result, the increase in the quantity of goods and services is smaller that it would have otherwise been.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Small Open Economy Considerations  A monetary injection by the B of C causes the dollar to depreciate, which causes net exports to rise shifting the AD curve to the right. Output increases by more than it would in a closed economy.  The B of C must allow the exchange rate to vary freely if its desire is to change the money supply.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Overview 4 The theory of liquidity preference. 4 The supply and demand for money.  How fiscal policy affects aggregate demand.  The economy in the long-run and short-run.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition How Fiscal Policy Influences Aggregate Demand  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 affects the aggregate demand.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Changes in Government Purchases  The federal government can influence the economy because – of the size of the central government in relation to the economy and other economic entities. – of the deliberate use of spending and taxes to manipulate the economy toward achieving a predetermined outcome.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Changes in Government Purchases  The federal government’s control of the economy is both direct and indirect. – Its expenditures have a direct effect on aggregate spending and therefore equilibrium GDP. – Taxes and tax policy indirectly affect the aggregate spending of consumers.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Changes in Government Purchases  There are two macroeconomic effects from government purchases: – The Multiplier Effect – The Crowding-Out Effect

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Multiplier Effect of Government Purchases  Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar — a multiplier effect.  The total impact of the quantity of goods and services demanded can be much larger than the initial impulse from higher government spending.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Multiplier Effect Price Level Quantity of Output AD 1

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Multiplier Effect Price Level Quantity of Output AD 1 AD 2 An increase in government purchases initially increases AD

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Multiplier Effect Price Level Quantity of Output AD 1 AD 2 The multiplier effect can amplify the shift in AD AD 3

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Multiplier Effect of Government Purchases  The formula for the multiplier is: Multiplier = 1 ÷ (1 - MPC)  the MPC is the Marginal Propensity to Consume.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Crowding-Out Effect  An increase in government purchases causes the interest rate to rise, and a higher interest rate tends to choke off the demand for goods and services.  The reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Changes in Taxes  When the government cuts taxes, it: – Increases households’ take-home pay, which... … results in households saving some of the additional income, but … households will spend some on consumer goods, thus … shifting the aggregate-demand curve to the right.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Open Economy Considerations  In a small, open economy, an expansionary fiscal policy causes the dollar to appreciate. Since this causes net exports to fall, there is an additional crowding-out effect that reduces the demand for Canadian produced goods and services.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Open Economy Considerations  If the B of C chooses to prevent any change in the exchange rate, an expansionary fiscal policy will have no crowding-out effect and will therefore cause a very large increase in the demand for goods and services.  For fiscal policy to have a lasting affect on the position of the aggregate- demand curve, the B of C must choose the appropriate exchange rate policy.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Changes in Taxes  The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier and crowding-out effects.  The duration of the shift in the aggregate demand is also determined by the B of C’s policy for the exchange rate (fixed or varied).

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Using Policy to Stabilize the Economy  Many policy-makers believe it necessary to use monetary and fiscal policy to achieve any level of aggregate demand and GDP that they wish. – Active monetary and fiscal intervention is necessary to tame an inherently unstable private sector. – The use of policy instruments stabilize aggregate demand and production and employment.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Using Policy to Stabilize the Economy  The use of government tax and spending policies to stabilize economic ups and downs in the short- run are called discretionary fiscal policies.  Generally, those that accept this approach to short-run economic stabilization follow the Keynesian theory of the economy.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Using Policy to Stabilize the Economy  Some economists argue that the government should avoid using monetary and fiscal policy to try to stabilize the economy. They suggest the economy should be left to deal with the short-run fluctuations on its own.  Discretionary Fiscal policy affects the economy with substantial lags.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Automatic Stabilizers  Automatic Stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policy-makers having to take any deliberate action.  Automatic stabilizers include: – The Tax System – Government Spending – Flexible Exchange Rate

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Quick Quiz!  Suppose firms become pessimistic about the future. What happens to aggregate demand?  If the B of C wants to stabilize aggregate demand, how should it alter the money supply? If it does this, what happens to the exchange rate?

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Overview The theory of liquidity preference. The supply and demand for money. How fiscal policy affects aggregate demand.  The economy in the long-run and short-run.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Economy in the Long-Run and Short-Run  When thinking about the long-run economy the Loanable Funds Theory is used to best describe the changes that occur.  When thinking about the short-run economy, the Liquidity-Preference Theory is used to best describe the changes that occur.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Economy in the Long-Run and Short-Run  In the Long-Run: – Output is determined by the supplies of capital and labour and the available production technology. – In a closed economy, the interest rate adjusts to balance the supply and demand for loanable funds. – The price level adjusts to balance the supply and demand for money.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition The Economy in the Long-Run and Short-Run  In the Short-Run: – The price level is stuck at some level and is relatively unresponsive to changing economic conditions. – The interest rate adjusts to balance the supply and demand for money. – The level of output responds to changes in the aggregate demand for goods and services.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Conclusion  Government macroeconomic policy should proceed carefully and with an understanding of the consequences of its policies in the short and long-run.  Fiscal policies can have long-run effects on saving, investment, the trade balance and growth.  Monetary policy can ultimately determine the level of prices and affect the inflation rate.

Principles of Macroeconomics: Ch. 20 Second Canadian Edition Overview The theory of liquidity preference. The supply and demand for money. How fiscal policy affects aggregate demand. The economy in the long-run and short-run.