1. Monetary and Fiscal Policies
IMBA Macroeconomics IV
Jack Wu

2. 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.

3. 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.

4. 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.

5. Aggregate Demand and Aggregate Supply
Price
Level
Aggregate
supply
Aggregate
demand
Equilibrium
output
price level
Quantity of
Output
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6. Aggregate Demand Curve
The four components of GDP (Y) contribute to the aggregate demand for goods and services.
Y = C + I + G + NX

7. The Aggregate-Demand Curve...
Price
Level
Aggregate
demand P Y
1. A decrease
in the price
level . . . Y2 P2
Quantity of
increases the quantity of
goods and services demanded.
Output
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8. Shifts Shifts arising from Consumption Investment Government Purchases
Net Exports

9. 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

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

11. The Long-Run Aggregate-Supply Curve
Price
Level
Long-run
aggregate
supply P
1. A change
in the price
level . . . P2
does not affect
the quantity of goods
and services supplied
in the long run.
Natural rate
Quantity of
of output
Output
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12. 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.

13. Shifts Shifts arising Labor Capital Natural Resources
Technological Knowledge

14. Long-Run Growth and Inflation
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
and
ongoing inflation. P
1990 P
1980 AD
1980 Y
1980
leading to growth
in output . . .
Quantity of
Output
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15. 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.

16. The Short-Run Aggregate-Supply Curve
Price
Level
Short-run
aggregate
supply Y P
1. A decrease
in the price
level . . . Y2 P2
reduces the quantity
of goods and services
supplied in the short run.
Quantity of
Output
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17. 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
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18. 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

19. A Contraction in Aggregate Demand
causes output to fall in the short run . . .
Price
Level
Short-run aggregate
supply, AS
Long-run
aggregate
supply
Aggregate
demand, AD
AS2
AD2
but over
time, the short-run
aggregate-supply
curve shifts . . . A P Y B P2 Y2
1. A decrease in
aggregate demand . . . C P3
and output returns
to its natural rate.
Quantity of
Output
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20. 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
and
the price
level to rise.
Quantity of
causes output to fall . . .
Output
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21. 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.

22. 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.

23. 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
policymakers can
accommodate the shift
by expanding aggregate
demand . . .
which
causes the
price level
to rise
further . . . P2 A P
but keeps output
at its natural rate.
Aggregate demand, AD
Natural rate
Quantity of
of output
Output
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24. 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
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25. 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.

26. 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
increases the
demand for money . . . r2
Money demand at
price level P , MD P2 Y2
which
increases
the
equilibrium
interest
rate . . .
1. An
increase
in the
price
level . . . r Y P
Aggregate
demand
Quantity fixed
Quantity
Quantity
which in turn reduces the quantity
of goods and services demanded.
by the Fed
of Money
of Output
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27. 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.

28. 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
the
equilibrium
interest rate
falls . . . r2
Aggregate
demand, A D
Quantity Y
Quantity
which increases the quantity of goods
and services demanded at a given price level.
of Money
of Output
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29. 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.

30. 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.

31. 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.

32. 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.

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

34. 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
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35. The Crowding-Out Effect
(a) The Money Market
(b) The Shift in Aggregate Demand
Interest
Price
which in turn
partly offsets the
initial increase in
aggregate demand.
Rate
Money
AD2
Level
supply
AD3
the increase in
spending increases
money demand . . .
$20 billion M D2
1. When an increase in government
purchases increases aggregate
demand . . . r2
which
increases
the
equilibrium
interest
rate . . . r
Aggregate demand, AD1
Money demand, MD
Quantity fixed
Quantity
Quantity
by the Fed
of Money
of Output
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