Post on 19-Dec-2015
Slides are prepared by Dr. Amy Peng, Ryerson University
Chapter ElevenChapter ElevenMonetary Policy and Fiscal Monetary Policy and Fiscal
Policy Policy in the Short Runin the Short Run
Macroeconomics by Curtis, Irvine and BeggMacroeconomics by Curtis, Irvine and BeggCanadian Edition, Canadian Edition, McGraw-Hill Ryerson, 2007McGraw-Hill Ryerson, 2007
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11 2
Learning OutcomesThis chapter explains:This chapter explains:• The relationship between prices, aggregate expenditure, and
aggregate demand• The determinants of the slope and the position of the AD
curve• Short-run equilibrium output and price• The objective of fiscal policy• The effects of fiscal policy on output, prices, and the public
debt• The effects of monetary policy on output and prices in the
short run• How monetary and fiscal policy interact• Recent monetary policy, fiscal policy, and economic
conditions in Canada
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.1 3
The Effect of Changes in the General Price Level on
Interest RatesIn
tere
st R
ate
i
M0/P
M0/P
L(Y0)
i0
i1
Real Money Balances
E
i2
M0/P1 M0/P2
M0/P1 M0/P2
ΔP>0 ΔP<0
Money Market Equilibrium
M0/P = L(Y,i)
A rise in P reduces the real money supply
A fall in P increases the real money supply
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.1 4
Changes in Interest Rates under Different Demand
ConditionsIn
tere
st R
ate
i
M0/P
M0/P
L(Y0)
i0
i2
Real Money Balances
Ei1
M0/P1
M0/P2
L0 is more Elastic than L1
L(Y1)
Less elastic of the money demand, the higher increase in interest rate given the same change of money supply.
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.1 5
Price, Aggregate Expenditure, and Aggregate Demand
• The linkages between change in the price level and changes in output can be summarized as follows:
YAENXer
ICrPMP
][
)/(
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.2 6
Deriving the AD Curve based on a Fixed Nominal Money Supply
Nom
inal
Int
eres
t R
ate
i
M0/P0
L(Y0)
i1
Real Money BalancesM0/P1
(a) Money Market
i2 Δi
The interest sensitivity of the demand for money as shown by the slope of demand curve for money balances.
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.2 7
Deriving the AD Curve based on a Fixed Nominal Money Supply
(b) Interest Rates and Expenditure
Rea
l Int
eres
t R
ates
A(r0) A(r1)
r0
r1
A(r)
The interest sensitivity of planned expenditure as shown by the slope of A(r).
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.2 8
Deriving the AD Curve based on a Fixed Nominal Money Supply
Exp
endi
ture
Y1
AE(r1)
A0(r1)
Real GDP
Y0
(c) Equilibrium Expenditure and Output
AE(r2)
A0(r0)
The size of the expenditure multiplier, which is determined by the slope of AE.
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.2 9
Deriving the AD Curve based on a Fixed Nominal Money Supply
P
Y1
AD0
P0
Real GDP
Y0
(d) Aggregate Demand
Y2
P1
P2
Changes in P cause movements along AD
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.3 10
Short-Run Equilibrium Output and Price
P
AD0
P0
Real GDP
Y0
AS0
Pric
e Le
vel
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.3 11
Short-Run Equilibrium Output and Price
P
AD0
P0
Real GDP
Y0
AS0
Pric
e Le
vel
(a) AD Shocks
AD1
AD2
Y1Y2
Demand shocks shift AD right and left, short-run equilibrium output and the price level move up and down together
P1
P2
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.3 12
Short-Run Equilibrium Output and Price
P
AD0
P0
Real GDP
Y0
AS0
Pric
e Le
vel
(b) AS Shocks
AS1
AS2
Y2Y1
Supply shocks shift AS up and down, short-run equilibrium output and the price level move in the opposite directions.
P1
P2
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.3 13
Short-Run Equilibrium Output versus Potential Output
P
AD0
P0
Real GDP
Yp
AS0
Pric
e Le
vel
AD1
AD2
Y1Y2
P1
P2 Potential GDP
Inflationary GapRecessionary Gap
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.4 14
The Effect of Fiscal Policy on AD
• Fiscal policy objectives – Stable aggregate demand consistent with full
employment and potential output– Control the debt ratio
• Fiscal policy instrument– Government’s budget balance
• Fiscal policy objectives are interdependent
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.4 15
Fiscal Policy and Aggregate Demand
P
AD0
P0
Real GDP
Yp
AS
Pric
e Le
vel
(a) Output and Price Level
AD1
Y1
Fall in autonomous expenditure shifts AD, income and output fall.
P1
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.4 16
(b) The Government Budget
Fiscal Policy and Aggregate Demand
0SBB1
Real GDP
Bud
get
Bal
ance
BB-
Yp
BB+
SBB0
Y1
BB(Y1
)
BB0
BB1
Income and Output fall, automatic stabilizers reduce BB.
Discretionary fiscal policy to offset a recessionary gap reduces structural budget balance.
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.4 17
Fiscal Policy and Aggregate Demand
P
AD0
P0
Real GDP
Yp
AS
Pric
e Le
vel
(a) Output and Price Level
AD1
Y1
AD shifts back, Y shifts back to potential GDP
P1
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.4 18
Fiscal Policy and the Public Debt
• BB = tY – G - iPD– iPD, annual interest paid on the outstanding
public debt
• PBB = tY - G– PBB, primary budget balance, excludes
interest payments on the public debt.
• SPBB = tYP - G– SPBB, structural primary budget balance
• BB = SPBB0 – t0(Y - YP) - iPD
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.4 19
Budget Balances and Outstanding Debt
• ΔPD = -BB– An overall budget surplus reduces the public
debt outstanding in the next year.– A budget deficit, increases it.
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.5 20
The Effects of Monetary Policy on AD
• Monetary policy affects the position of the AD curve.
• M = M0 – (Y – YP)
– The bank reacts to short-run differences between actual and potential output by setting the nominal money supply
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.5 21
Monetary Policy and Potential Output
P
AD0
P0
Yp
AS0
Pric
e Le
vel
(a) Short Run Output and Price
AD1
Y1
A rise in aggregate expenditure shifts AD
P1
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.5 22
Monetary Policy and Potential Output
M0
Real GDP
Yp
Nom
inal
Mon
ey S
uppl
y(b) Monetary Policy
Y1
Bank lowers money supply
M1
M = M0 – (Y – YP)
M = M1 – (Y – YP)
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.5 23
Monetary Policy and Potential Output
P
AD0
P0
Yp
AS0
Pric
e Le
vel
(a) Short Run Output and Price
AD1
Y1
The new monetary policy shifts AD back.
P1
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.6 24
Interaction between Monetary and Fiscal Policy
• There are two ways to increase AD1. Expansionary fiscal policy and tight
monetary policy– Crowding out effect
2. Tight fiscal policy and easy monetary policy
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11.7 25
Recent Economic Performance and Policy in Canada
1985-1989
1990-1994
1995-1999
2000-2004
1. Output Gap (%) 0.88 -2.20 -0.86 0.43
2. Unemployment rate (%) 8.91 10.33 8.89 7.31
3. Inflation rate (%) 4.30 2.62 1.62 2.43
4. Public debt/GDP (%) 53.20 64.90 71.10 52.00
5. Real overnight rate (%) 5.30 4.89 3.20 1.03
6. Structural primary budget balance ($ billion)
-8.78 6.56 42.68 51.25
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11 26
Chapter Summary
• Aggregate demandAggregate demand is the relationship between the general price level and equilibrium real GDP.
• Aggregate demand integrates the explanation of equilibrium aggregate expenditureequilibrium aggregate expenditure, the money and financial markets, monetary policy and fiscal policy into a price/output function.
• Central bank conduct monetary policy using its its control and setting of the money supplycontrol and setting of the money supply.
• How to determine the slope and position of ADthe slope and position of AD.
©2007 McGraw-Hill Ryerson Ltd.
Chapter 11 27
Chapter Summary
• Short-run aggregate supplyShort-run aggregate supply• AD and AS determine short-run equilibrium real short-run equilibrium real
GDP and priceGDP and price.• Monetary policyMonetary policy is a demand management tool.• Fiscal policyFiscal policy is a demand management tool.• The mix of monetary and fiscal policymix of monetary and fiscal policy is
important.• Indicators of monetary and fiscal policy show
that in the past 20 years Canadian policy was primarily concerned with the reduction and control of inflationcontrol of inflation and with control and reduction of the public debtreduction of the public debt.