1. MACROECONOMICS BY CURTIS, IRVINE, AND BEGG SECOND CANADIAN EDITION MCGRAW-HILL RYERSON, © 2010 Chapter 11 Monetary Policy and Fiscal Policy in the Short Run

2. Learning Outcomes ©2010 McGraw-Hill Ryerson Ltd. Chapter 11 2 This chapter explains: Prices, aggregate expenditure and aggregate demand The slope and the position of the AD curve The slope and position of the AS curve Short-run equilibrium output and price The objective of fiscal policy Fiscal policy impacts on output, prices and public debt Monetary policy impacts on output and prices How monetary and fiscal policy interact Recent monetary policy, fiscal policy, and economic conditions in Canada

3. Prices, Aggregate Expenditure & Aggregate Demand ©2010 McGraw-Hill Ryerson Ltd. Chapter 11.1 3 Driving the AD curve: Assume a fixed nominal money supply (M) In the money market: Real money supply ≡ M/P Demand for real money balances: L = kY – hi ∆P  ∆(M/P)  M/P curve shifts ∆(M/P)  ∆i ∆i  ∆AE & ∆Y by transmission mechanism

4. The Effect of ∆P on Interest Rates ©2010 McGraw-Hill Ryerson Ltd. Chapter 11.1 4 Interest Rate i M 0 /P L(Y 0 ) i0i0 i1i1 Real Money Balances i2i2 M 0 /P 1 M 0 /P 2 M 0 /P 1 M 0 /P 2 ΔP>0ΔP<0 Money Market Equilibrium M 0 /P = L(Y,i) A rise in P reduces M/P  ↑i A fall in P increases M/P  ↓i ∆i/∆P > 0

5. Changes in Interest Rates under Different Demand Conditions ©2010 McGraw-Hill Ryerson Ltd. Chapter 11.1 5 Interest Rate i M 0 /P L 0 (Y 0 ) i0i0 i2i2 Real Money Balances i1i1 M 0 /P 1 L 0 (Y 0 ) is more i elastic than L 1 (Y 0 ) L 1 (Y 0 ) Less i elastic L  greater ∆i/∆P (i 2 – i 0 ) > (i 1 – i 0 ) ∆P<0 ∆P > 0  shift M/P  M 0 /P 1

6. Price, AE, Equilibrium Y & AD The transmission mechanism links ∆P to AE and equilibrium Y ∆Y/∆P is the movement along an AD curve © 2010 McGraw-Hill Ryerson Ltd. Chapter 11.1 6

7. Price, AE & Equilibrium Y & AD Initial equilibrium: L = M 0 /P 0 giving i 0 (Nominal money supply is fixed) Y = A(i 0 )/ [1 - c(1-t) +z] Then assume ∆P > 0 ∆P  ↓M/P  ↑i ↑i  ↓ A(i)  ↓equilibrium Y ∆P  ∆ equil Y ≡ movement along AD curve ©2010 McGraw-Hill Ryerson Ltd. Chapter 11.1 7

8. Deriving the AD Curve based on a Fixed Nominal Money Supply ©2010 McGraw-Hill Ryerson Ltd.Chapter 11.1 8 (a) Money Market(b) Interest Rates and Expenditure Interest Rate i1i1 i0i0 M 0 / P 1 M 0 / P 0 A(i 1 ) Real GDP (d) Aggregate Demand(c) Equilibrium expenditure & output A(i 0 ) A(i) ExpenditurePrice Level Interest Rate i1i1 i0i0 A(i 0 ) A(i 1 ) P0P0 P1P1 P2P2 AE(P 0 ) AE(P 1 ) Y = AE Y1Y1 Real GDPY0Y0 Y1Y1 Y0Y0 Y2Y2 F G H AD 0 ∆P∆P M/P L A(i) ∆Y ↑P↑P

9. Slope & Position of AD 9 Chapter 11.2 ©2010 McGraw-Hill Ryerson Ltd. Slope of AD determined by: 1. Interest sensitivity of L 2. Interest sensitivity of A(i) 3. Size of the multiplier Position of AD determined by: 1. Nominal money supply set by central bank 2. Autonomous expenditure A 3. Monetary transmission mechanism 4. Size of the multiplier

10. Short Run Aggregate Supply Curve Short-run AS curve: Relationship between output of goods and services and the price level: ∆P/∆Y >0 Short run AS is based on: Constant wage rates (w) & other factor prices Given stock of capital Given size of the labour force Constant indirect taxes Constant prices of key raw-materials (for example, crude oil) ©2010 McGraw-Hill Ryerson Ltd. Chapter 11.3 10

11. Short Run Aggregate Supply Curve Position of AS curve determined by: Factor prices & productivity (esp. w & Y/N) Capital stock, labour force & technology Raw materials prices & indirect taxes Slope of AS curve shows: Flexibility or stickiness of P Structure of industry & producer price/output decisions Changes in unit costs as output changes ©2010 McGraw-Hill Ryerson Ltd. Chapter 11.3 11

12. Short Run Aggregate Supply Curve © 2010 McGraw-Hill Ryerson Ltd. Chapter 11.3 12 P Y0Y0 P0P0 P1P1 Y1Y1 AS 0 (w 0 ) AS 1 (w 1) ∆w Upward sloping AS shows a positive relationship between P&Y Falling factor productivity as Y rises Y 0  Y 1 rising unit costs Producers need higher prices P 0  P 1 to cover rising cost & maintain profit A rise in wage rates, w, raises unit labour costs at all Y  AS shifts up & P rises at all Y P2P2

13. Short-Run Equilibrium Output and Price © 2010 McGraw-Hill Ryerson Ltd. Chapter 11.4 13 AD 0 P0P0 Real GDP Y0Y0 AS 0 Price Level AD and AS determine equilibrium Y & P based on a given set of expenditure, output and pricing decisions

14. Aggregate Demand (AD) Shocks Changes in A  shift AD: ∆A < 0  shift AD left  ↓ Y & ↓ P ∆A > 0  shift AD right  ↑ Y & ↑ P ∆A  ∆P & ∆Y in the same direction Fluctuations in A  business cycles in P & Y ©2010 McGraw-Hill Ryerson Ltd. Chapter 11.4 14 P P0P0 P2P2 P1P1 AS 0 AD 0 AD 2 AD 1 Y1Y1 Y0Y0 Y2Y2 Y

15. Aggregate Supply (AS) Shocks ∆ costs  shift AS: ∆w >0, or ∆P oil >o  shift AS ↑ ↑ costs  ↑ price at every Y  ↑P & ↓Y ∆P oil < o, or ∆w< 0 or better technology  ↓ unit costs  AS shift ↓  ↓P at every Y ∆Costs  shift AS  ∆P & ∆Y in opposite directions ©2010 McGraw-Hill Ryerson Ltd. Chapter 11.4 15 P AS 1 AS 0 AS 2 P1P1 P0P0 P2P2 AD 0 ∆w>0 ∆w<0 Y1Y1 Y0Y0 Y2Y2 Y

16. Short-Run Equilibrium Y versus Y P © 2010 McGraw-Hill Ryerson Ltd. Chapter 11.4 16 P AD 0 P0P0 Real GDP YpYp AS 0 Price Level AD 1 AD 2 Y1Y1 Y2Y2 P1P1 P2P2 YPYP Short run Y & P depend on AD Y P depends on labour force, capital stock & technology AD 0  Y e = Y p Higher AD 1  Inflationary gap Y 1 > Y P Lower AD 2  recessionary gap Y 2 < Y P Fluctuations in AD, AD 1 ↔ AD 2  business cycles in Y Persistent weak AD like AD 2  recession like 2008 -2009

17. Short run AD/AS & Economic Policy Persistent output gaps arise if factor and output prices are slow to adjust Persistent output gaps may also arise if business & household confidence and expectations of future economic conditions are low Monetary & fiscal policies offer solutions to persistent short-run fluctuations in output, employment and prices. ©2010 McGraw-Hill Ryerson Ltd. Chapter 11.4 17

18. The Effect of Fiscal Policy on AD Chapter 11.5 18 Fiscal policy objectives  Stable AD consistent with Y = Y P & full employment output  Control the public debt ratio, PD/Y Fiscal policy instrument  Government’s BB = tY – G  t & G are policy instruments within BB  ∆t &/or ∆G  ∆BB  ∆AD  ∆Y & ∆P Fiscal policy objectives are interdependent  ∆BB  ∆PD © 2010 McGraw-Hill Ryerson Ltd.

19. Fiscal Policy and Aggregate Demand ©2010 McGraw-Hill Ryerson Ltd. Chapter 11.5 19 Fiscal Policy with a Y P target Suppose ↓AD  recessionary gap (eg Canada 2008--) Fiscal stimulus plan:  New spending on infrastructure etc. = ∆G > 0  ∆G > 0  ∆BB < 0  ↓ shift in BB function  ∆G & ∆BB  ∆AD but if BB <0  ↑PD Expansionary Fiscal policy  Y = Y P may conflict with Fiscal Policy  PD control In diagrams ……

20. Fiscal Policy and Aggregate Demand ©2007 McGraw-Hill Ryerson Ltd. Chapter 11.5 20 P AD 0 P0P0 Real GDP YpYp AS AD 1 Y1Y1 P1P1 YPYP gap BB+ SBB 0 0 BB(Y 1 ) SBB 1 BB 2 –G 0 –G 1 YPYP YPYP BB 0 = t 0 Y – G 0 BB 1 =t 0 Y – G 1 ∆G Y1Y1 Intial Y e = Y P ↓A  ↓AD  Y 1 and Recessionary gap Initial BB 0 with SBB 0 >0 at Y P Fiscal stimulus = ↑G  BB 1 & SBB 1 SBB 1 < 0  ↑PD Auto stabilization  BB(Y 1 ) ∆A ∆G ↑ G  ↑ AD  Y P Y

21. Fiscal Policy and the Public Debt 21 Fiscal Policy with a PD/Y target In 2005 Govt of Canada set debt ratio (PD/Y) targets Fiscal Policy & Budget Implications: Public Debt >0  interest costs = iPD BB = tY – G – iPD, PBB = tY – G, PBB is the primary budget balance. SPBB = tY P – G, the Structural Primary budget balance, ©2007 McGraw-Hill Ryerson Ltd.Chapter 11.5

22. Fiscal Policy & the Public Debt 22 The Budget Balance  changes in the public debt ∆PD = -BB Then: Debt control: ∆PD = 0 requires BB = 0 BB = tY – G – iPD, and BB = 0 requires tY – G = iPD To achieve ∆PD = 0, Fiscal policy sets t & G to get a Primary Budget Balance = interest cost of PD ©2007 McGraw-Hill Ryerson Ltd. Chapter 11.5 Fiscal policy Y Stabilization & PD control targets may conflict

23. The Effects of Monetary Policy on AD © 2010 McGraw-Hill Ryerson Ltd. Chapter 11.6 23 With equilibrium P constant: Monetary policy target: Y = Y P Monetary policy instrument is M setting. Policy rule : M = M 0 –  (Y – Y P ) Stabilization from ∆M when (Y – Y P ) ≠ 0 In diagrams………

24. Monetary Policy to Close an Inflationary Gap ©2007 McGraw-Hill Ryerson Ltd. Chapter 11.6 24 YPYP AD 0 P0P0 YpYp AS 0 AD 1 Y1Y1 P1P1 Y P M = M 0 – γ(Y – Y P ) YPYP YPYP M M0M0 Y M1M1 Y1Y1 Equilibrium Y = Y P, P = P 0 M = M 0 gap ∆A>0  ↑AD – Y > Y P Y>Y P  ↓M  M 1 ↓M  ↑i  ↓A  ↓AD  Y = Y P ∆A ∆M Permanent ∆A  reset policy rule to M = M 1 – γ(Y – Y P )

25. Interaction between Monetary and Fiscal Policy ©2007 McGraw-Hill Ryerson Ltd. Chapter 11.7 25 Fiscal expansion when Y ≈ Y P  tight monetary policy to prevent inflationary gap. ↓i & ↑er crowd out A(i)  ↑G sector and ↓ C, I, X, Z Fiscal restraint  control PD  ↓AD  monetary stimulus: ↓ i and ↑ er  ↑A  ↑ private sector offset ↓G Monetary restraint & fiscal restraint in early 1990’s  ‘Great Canadian Slump’ Financial crisis & recession 2008-09  fiscal stimulus & monetary stimulus.

26. Economic Performance and Macroeconomic Policy in Canada 1985 -2008 © 2010 McGraw-Hill Ryerson Ltd. Chapter 11.8 26 1985-1989 1990-1994 1995-1999 2000-2004 2005-2008 1. Output gap (%) 0.88 -2.20 -0.86 0.42 0.83 2. Unemploy rate (%) 8.91 10.33 8.89 7.31 6.28 3. Inflation rate (%) 4.30 2.62 1.62 2.43 2.03 4. Public debt/GDP (%) 53.20 64.90 71.10 52.00 37.10 6.Structural primary BB ($billions) -8.78 6.56 42.68 51.25 33.79 5. Real overnight i (%) 5.30 4.89 3.20 1.03 1.66 Key Indicators of Macroeconomic Performance Recessionary gap 1990 – 99, tight monetary policy & strong fiscal restraint Small inflationary gaps 2000 – 08, easy money, mild fiscal stimulus, low inflation, falling unemployment & falling debt ratio

27. The Start of the 2008 and 2009 Recession Chapter 11.8 27 © 2010 McGraw-Hill Ryerson Ltd. Macroeconomic indicators (% or annualized %∆) 2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 ∆Real GDP (annual rate) – 0.7 – 0.1 0.4 – 3.1 – 7.0 Output gap 0.9 0.6 0.2 – 1.1 – 3.5 Unemploy rate 6.1 6.1 6.4 7.6 8.0 Inflation rate 1.5 3.0 3.3 1.2 1.4 ∆Commodity prices 52.4 92.1 – 26.5 – 78.8 – 46.6 Overnight interest rate 3.5 3.0 3.0 1.5 0.5 ↓ GDP growth  recessionary gap, ↑ unemployment & ↓ inflation ∆Fed Govt BB shows automatic stabilization Monetary policy reacts with cuts in overnight rate from 3.5  0.5 Fed Govt BB ($bil) 2.98 0.77 – 0.68 – 1.62 – 2.57

28. Chapter Summary © 2010 McGraw-Hill Ryerson Ltd. Chapter 11 28 Aggregate demand Aggregate demand (AD): the relationship between P & equilibrium Y AD integrates Y = AE with M/P through the monetary transmission mechanism money supply M Traditional approach: AD based on fixed money supply M. Slope of AD: determined by (∆A/∆i) & multiplier Position of AD: determined by A & multiplier the relationship between real GDP & P when factor prices are constant Short-run AS: the relationship between real GDP & P when factor prices are constant

29. Chapter Summary © 2010 McGraw-Hill Ryerson Ltd. Chapter 11 29 Slope of AS: determined by changes in unit costs as output changes and output – pricing decisions of producers Position of AS: determined by factor prices, capital stock, technology, indirect taxes etc. real GDP and price AD and AS determine short-run equilibrium real GDP and price. Monetary policy Monetary policy is a demand management tool. Fiscal policy Fiscal policy is a demand management tool. reduction. Macroeconomic Indicators show that in the 25 years before 2008 Canadian policy targeted inflation control debt reduction. The recession of 2008 – 09 shifted policy to Monetary and Fiscal stimulus