Monetary and Fiscal Policy Interact Unit 5 Lesson 2 Activity 45 By John Morton Advanced Placement Economics Teacher Resource Manual. National Council on Economic Education, New York, N.Y

Objectives Practice analytical skills with AD and SRAS model and the money market. Analyze the effects of combined monetary and fiscal policies on the loanable funds market.

Introduction This lesson continues an examination of the interaction between monetary and fiscal policy in the short-run. It examines the impact of monetary and fiscal policy on output, the price level, unemployment, interest rates and investment. Your success on the AP Exam depends on your ability to explain why economic variables are affected.

Activity 45 provides you with an opportunity to work through the short-run effects of monetary and fiscal policy on important macroeconomic variables. You will continue to use the loanable funds market and the money market in this activity. (The following slides are not on your activity sheet.)

The Effects of Policy Changes in Multiple Markets Loanable Funds Market Money Market AD and AS Interest Rate Interest Rate PL MS SRAS S p i MD AD D Loanable Funds Y GDPR I Money Suppose that, in response to the economic situation, the federal government decides to increase its spending without increasing taxes and the Fed keeps the money supply constant. There is no Barro-Ricardo effect. Explain what would happen in the three markets shown above.

The AD curve should shift to the right. Loanable Funds Market Money Market AD and AS Interest Rate Interest Rate PL MS SRAS S i1 p1 p i MD1 MD D1 AD1 AD D Loanable Funds Y Y1 GDPR I I1 Money The AD curve should shift to the right. Increase the demand for loanable funds by shifting the curve to the right. The demand for money should also shift to the right. The interest rates in the money market and loanable funds should be equal.

What happened to each of the following variables and why: Loanable Funds Market Money Market AD and AS Interest Rate Interest Rate MS SRAS S i1 p1 p i MD1 MD D1 AD1 AD D Loanable Funds Y Y1 GDPR I I1 Money What happened to each of the following variables and why: Output (real GDP): Increased. AD increased because of the increase in government spending

Employment: Price level: Loanable Funds Market Money Market AD and AS Interest Rate Interest Rate MS SRAS S i1 p1 p i MD1 MD D1 AD1 AD D Loanable Funds Y Y1 GDPR I I1 Money Employment: Price level: Increased. AD increased because of the increase in government spending Increased. AD increased because of the increase in government spending

Loanable Funds Market Money Market AD and AS Interest Rate Interest Rate MS SRAS S i1 p1 p i MD1 MD D1 AD1 AD D Loanable Funds Y Y1 GDPR I I1 Money Interest rates: Increased. With the money supply held constant, the demand for money increased or the demand for loanable funds increased.

Investment: Decreased because of the increase in interest rates Loanable Funds Market Money Market AD and AS Interest Rate Interest Rate MS SRAS S i1 p1 p i MD1 MD D1 AD1 AD D Loanable Funds Y Y1 GDPR I I1 Money Investment: Decreased because of the increase in interest rates

Was there crowding-out present in the above graphs? Loanable Funds Market Money Market AD and AS Interest Rate Interest Rate MS SRAS S i1 p1 p i MD1 MD D1 AD1 AD D Loanable Funds Y Y1 GDPR I I1 Money Was there crowding-out present in the above graphs? In the Loanable Funds Market graph, the government’s demand for funds increased the interest rate.

Answer the following questions: What could the Fed have done to prevent crowding-out? Are there certain conditions when the Fed should or should not prevent crowding-out? The Fed could use expansionary monetary policy; thus the government’s demand for funds would not result in an increase in interest rates. If the economy were experiencing a recession, the Fed would want to prevent crowding-out, but if the economy were at or near full employment and government spending increased, the Fed might not want to prevent crowding-out.

Graphing Monetary and Fiscal Policy Interactions Illustrate the short-run effects for each monetary and fiscal policy combination using AD and AS curves, the money market and the loanable funds market. Once again, assume that there are no changes in the foreign sector. Circle the appropriate symbols (↑ for increase, ↓ for decrease, and ? for uncertain), and explain the effect of the policies on real GDP, the price level, unemployment, interest rates and investment.

The unemployment rate is 10%, and the CPI is increasing at a 2% rate The unemployment rate is 10%, and the CPI is increasing at a 2% rate. The federal government cuts personal income taxes and increase its spending. The Fed buys bonds on the open market. Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate MS SRAS S p i MD AD D Loanable Funds Y GDPR I Money

Expansionary Monetary and Fiscal Policy Money Market AD and AS PL Interest Rate Interest Rate MS MS1 SRAS S S1 p1 i1 p i AD1 MD1 D1 MD AD D Loanable Funds Y Y1 GDPR I Real GDP: ? Explain Both policies are expansionary: C, G & I will all increase.

Expansionary Monetary and Fiscal Policy Money Market AD and AS PL Interest Rate Interest Rate MS MS1 SRAS S S1 p1 i1 p i AD1 MD1 D1 MD AD D Loanable Funds Y Y1 GDPR I (B) The Price Level: ? Explain The increase in AD will increase the PL

Expansionary Monetary and Fiscal Policy Money Market AD and AS PL Interest Rate Interest Rate MS MS1 SRAS S S1 p1 i1 p i AD1 MD1 D1 MD AD D Loanable Funds Y Y1 GDPR I (C) Unemployment: ? Explain The increase in AD will increase employment and output.

Expansionary Monetary and Fiscal Policy Money Market AD and AS PL Interest Rate Interest Rate MS MS1 SRAS S S1 p1 i1 p i AD1 MD1 D1 MD AD D Loanable Funds Y Y1 GDPR I (D) Interest Rates: ? Explain Fiscal policy would result in an increase in interest rates; monetary policy would result in lower interest rates. The net effect depends on the relative strength of the two policies. The graph here shows a slight increase in interest rates; the effect on interest rates is indeterminate.

Expansionary Monetary and Fiscal Policy Money Market AD and AS PL Interest Rate Interest Rate MS MS1 SRAS S S1 p1 i1 p i AD1 MD1 D1 MD AD D Loanable Funds Y Y1 GDPR I (E) Investment: ? Explain Because we can’t tell what happens to interest rates, we can’t say what happens to investment because of changes in the interest rate.

2. The unemployment rate is 6%, and the CPI is increasing at a 9% rate 2. The unemployment rate is 6%, and the CPI is increasing at a 9% rate. The federal government raises personal income taxes and cuts spending. The Federal Reserve sells bonds on the open market. Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate MS SRAS S p i MD AD D Y I Loanable Funds GDPR Money

Contractionary Monetary and Fiscal Policy Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate MS1 MS S1 SRAS S p i p1 MD AD D AD1 D1 MD1 Loanable Funds Y1 Y GDPR I Money (A) Real GDP: ? Explain Decreased AD should lower GDP somewhat. AD decreases because of contractionary monetary and fiscal policy.

Contractionary Monetary and Fiscal Policy Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate MS1 MS S1 SRAS S p i p1 MD AD D AD1 D1 MD1 Loanable Funds Y1 Y GDPR I Money (B) The Price Level: ? Explain The decrease in AD should result in a lower PL

Contractionary Monetary and Fiscal Policy Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate MS1 MS S1 SRAS S p i p1 MD AD D AD1 D1 MD1 Loanable Funds Y1 Y GDPR I Money (C) Unemployment: ? Explain Lower output decreases employment on the SRAS curve.

Contractionary Monetary and Fiscal Policy Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate MS1 MS S1 SRAS S p i p1 MD AD D AD1 D1 MD1 Loanable Funds Y1 Y GDPR I Money (D) Interest rates: ? Explain The Fed decreases the money supply, which should result in an increase in interest rates. The increase in taxes and decrease in government spending result in a decrease in interest rates since the demand for loanable funds by the government should decrease. The demand for money decrease because of the decrease I real GDP. Interest rates will be higher if the decrease in demand is less than the decrease in supply in the money market. The interest rate effect is indeterminate.

Contractionary Monetary and Fiscal Policy Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate MS1 MS S1 SRAS S p i p1 MD AD D AD1 D1 MD1 Loanable Funds Y1 Y GDPR I Money (E) Investment: ? Explain If interest rates are higher; there would be a decrease in the level of investment. If interest rates are lower, there would be an increase.

The unemployment rate is 6%, and the CPI is increasing at a 5% rate The unemployment rate is 6%, and the CPI is increasing at a 5% rate. The federal government cuts personal income taxes and maintains current spending. The Fed sells bonds on the open market. Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate S MS SRAS p i AD D MD Y I Loanable Funds GDPR Money

Contractionary Monetary Policy and Expansionary Fiscal Policy Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate MS1 MS S1 SRAS i1 S p i AD D1 MD D Y Loanable Funds GDPR I Money (A) Real GDP: ? Explain The combined effect on AD is impossible to predict. The fiscal policy is expansionary, and the monetary policy is contractionary.

Contractionary Monetary Policy and Expansionary Fiscal Policy Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate MS1 MS S1 SRAS i1 S p i AD D1 MD D Y Loanable Funds GDPR I Money (B) Price Level: ? Explain The impact on the price level is impossible to predict given the contradicting monetary and fiscal policies.

Contractionary Monetary Policy and Expansionary Fiscal Policy Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate MS1 MS S1 SRAS i1 S p i AD D1 MD D Y Loanable Funds GDPR I Money (C) Unemployment: ? Explain The impact on output and, hence, employment is impossible to predict given the contradicting monetary and fiscal policies.

Contractionary Monetary Policy and Expansionary Fiscal Policy Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate MS1 MS S1 SRAS i1 S p i AD D1 MD D Y Loanable Funds GDPR I Money (D) Interest rates: ? Explain Interest rates will rise because of the increased demand for and reduced supply of loanable funds.

Contractionary Monetary Policy and Expansionary Fiscal Policy Loanable Funds Market Money Market AD and AS PL Interest Rate Interest Rate MS1 MS S1 SRAS i1 S p i AD D1 MD D Y Loanable Funds GDPR I Money (E) Investment: ? Explain The increase in interest rates will tend to decrease investments.