Chapter 34 – The Influence of Monetary and Fiscal Policy on Aggregate Demand

• Money Market - the financial market in which financial instruments with high liquidity and very short maturities are traded

– Used by participants as a means for borrowing and lending in the short term; from several days to just under a year.

– Money market securities consist of certificates of deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).

Chapter 34 – The Influence of Monetary and Fiscal Policy on Aggregate Demand

Money Market Graph

Interestrate

Quantity of Money

r1

Moneydemand

Md1

r2

Md2

Money supply

Quantity Fixed by the Fed

EquilibriumInterest rate

Increase in Money SupplyA Monetary Injection

Interestrate

Quantityof money

0

(a) The Money Market

Money demandat price level P

Money supply, MS1

r1

1. When the Fedincreases themoney supply . . .

MS2

r2

2. . . . the equilibriuminterest rate falls . . .

Increase in Money Demand

Interestrate

Quantityof money

0

Money demand atprice level MD1

Moneysupply

Quantity fixedby the Fed

Money demand atprice level MD2

r2

r1

1. . . . increases thedemand for money . . .

2. . . . which increasesequilibrium interest rate . . .

Application – The Money Market

Interestrate

Quantityof money

0


Money demandat price level P

Money supply, MS2

r2

MS1

r1

Scenario: The Federal Reserve sells bonds in open-market operations. Scenario: The Federal Reserve sells bonds in open-market operations.

Application – The Money Market

Interestrate

Quantityof money

0


MD

Money supply, MS1

r1

MS2

r2

Scenario: The Federal Reserve buys bonds in open-market operations. Scenario: The Federal Reserve buys bonds in open-market operations.

• Fiscal Policy – Government spending policies that influence the macroeconomy.• These policies affect tax rates and government spending, in an effort to

stabilize/control the economy. – Expansionary Fiscal Policy – involves increased government spending to

stimulate the economy during or in anticipation of a business-cycle contraction– Contractionary Fiscal Policy - a decrease in government spending to slow the

economy down during an inflationary economy

Fiscal Policy and The Federal Budget

Two Tools of Fiscal Policy• Tax Policy – increase or decrease percentage of

revenue from individual households and firms• Government Spending – increase or decrease in

discretionary spending to affect AD

Tools of Fiscal Policy

Example Tax Credits

• Proportional Tax – % of income taxes remains the same for all income levels (Flat tax)

• Progressive Tax – % of income paid in taxes increases as income increases (Federal Income Tax)

• Regressive Tax - % of income paid in taxes decreases as income increases (Sales Tax)

Tax Structures

Tax Structure ExamplesType of Tax Income of $10,000 Income of $100,000 Summary

Proportional10% flat tax = $1,000 • 10% of income

10% flat tax = $10,000 • 10% of income

As income goes up, the percent of income taxed stays the same

Progressive10% income tax = $1,000 •10% of income

25% income tax = $25,000•25% of income

The more you make, the more they take.

Regressive6% State Sales Tax$5,000 in consumer goods = $300• 3% of income

6% State Sales Tax$20,000 in consumer goods = $1200•1.2 % of income

The more you make the less they take.

Who Bears the Burden?

What are the three tax structures and who bears the burden of each?1. Progressive – more you make, more they take.

Rich bear the burden.2. Regressive – more you make, less they take.

Poor bear the burden3. Proportional – everyone pays the same

percentage. The burden is spread equally amongst people in the economy.

Expansionary vs. Contractionary Fiscal Policy– Expansionary Fiscal Policy - increased

spending, tax cuts to stimulate AD– Contractionary Fiscal Policy – reduced

spending, tax hikes to slow down AD

How Fiscal Policy Influences Aggregate Demand

Tax Video

• http://www.youtube.com/watch?v=iVAybRTmIyw

http://www.youtube.com/watch?v=iVAybRTmIyw

http://www.youtube.com/watch?v=iVAybRTmIyw

• Tax Bracket – scheduled rate at which you are taxed based on your annual income

• Marginal tax rate – is the tax rate that applies to the last unit of currency

Individual Income Taxes


$934.00

• http://www.irs.gov/pub/irs-pdf/f1040.pdf

http://www.irs.gov/pub/irs-pdf/f1040.pdf



• Taxable Income – A person’s gross income minus exemptions and deductions (link)


http://acadwebsnhu.snhu.edu/vita/Examples%20of%20Taxable%20Income.pdf

Tax Deductions

• http://www.youtube.com/watch?v=EFI2Fuq3dP8

http://www.youtube.com/watch?v=EFI2Fuq3dP8

http://www.youtube.com/watch?v=EFI2Fuq3dP8


-Example: A person with an income of $10,000-$8,375 x .10 = $837.5-$1625 x .15 = $243.75-Total tax paid = $837.5 + $243.75 = $1081.25

Bush Tax Cuts – “Fiscal Cliff”

http://www.cbsnews.com/video/watch/?id=50135875n

Bush Tax Cuts – “Fiscal Cliff”

http://www.cbsnews.com/video/watch/?id=50135875n

• FICA (Federal Insurance Contributions Act) – payroll tax, funds Social Security and Medicare.

• Social Security – funds people of old-age, survivors and disabilities, established in 1935, originally to provide old-age pensions of workers

• Medicare – national health insurance program that helps pay for people over age of 65 or with certain disabilities

• Medicaid – national health insurance for people within the poverty threshold

• Unemployment – insurance for workers laid off through no fault of their own

Other Types of Taxes

Payroll tax Video

• http://www.youtube.com/watch?v=yB1DdBP3FH0&list=PL6C78E46B824BFF89&index=7&feature=plpp_video

http://www.youtube.com/watch?v=yB1DdBP3FH0&list=PL6C78E46B824BFF89&index=7&feature=plpp_video




• Excise tax – tax on specific goods, cigarettes, alcohol, phone service, cable, internet, etc.

• Estate tax – “death tax”, tax on estate or value of money and property of a person who has died

• Gift tax – tax on money or property that one living person gives to another; a person can give up to $14,000 a year tax-free per individual

• Tariff – import tax on foreign goods brought into the country

Other Types of Taxes

Who bears the burden?

What are the three tax structures and who bears the burden of each?1. Progressive – more you make, more they take.

Rich bear the burden.2. Regressive – more you make, less they take.

Poor bear the burden3. Proportional – everyone pays the same

percentage. The burden is spread equally amongst people in the economy.

• Mandatory Spending – programs that lawmakers are required by existing laws to spend money on (Social Security, Medicare, Medicaid, etc.)

• Discretionary Spending – spending that government can adjust; increase or decrease (Defense, environment, scientific research, etc.)

Federal Spending

Fiscal Policy and The Federal Budget

The Federal Budget

Budget Deficit

Budget Deficits and the National Debt

Government Video

• http://www.youtube.com/watch?v=rG1DUn8mMwk&list=PL6C78E46B824BFF89&index=1&feature=plpp_video

http://www.youtube.com/watch?v=rG1DUn8mMwk&list=PL6C78E46B824BFF89&index=1&feature=plpp_video



• Balanced budget – money going into the U.S. Treasury is the same amount of money going out– Revenue = Spending– The last balanced budget occurred in 1997 under

President Bill Clinton


• Budget Surplus – occurs when the government takes in more than it spends– Revenue > Spending

• Budget Deficit – occurs when the government spends more than it takes in– Revenue < Spending

Balancing the Budget

• Reduce Spending – cut spending on government programs• Increase Taxes• Print money – the government can print or inject money into

economy• Borrow money – government borrows money by selling bonds on the

primary market– Bonds sold domestically or globally– China owns 1 trillion dollars in U.S. bonds

Dealing with a Budget Deficit

• National debt – the total amount of money the federal government owes to bondholders

• Combination of all borrowing over time• Budget deficit – the amount of money the government owes

to bondholders in one fiscal year

The National Debt

China Video

• http://www.youtube.com/watch?v=rG1DUn8mMwk&list=PL6C78E46B824BFF89&index=1&feature=plpp_video





• Keynesian economics - macroeconomic theory of 20th century British economist John Maynard Keynes. – Laissez Faire (no government

interference) in private sector can lead to inefficient macroeconomic outcomes

– Advocates active policy responses by the public sector (monetary policy and fiscal policy) to stabilize the business cycle

– Book

Keynesian Economics

• Advocates a mixed economy, predominantly private sector, but with a large role of government and public sector

• Served as the economic model during the latter part of the Great Depression, World War II, and the post-war economic expansion (1945–1973)

• Lost influence until the global financial crisis in 2007, which caused a resurgence in Keynesian thought. – President George W. Bush was heavily

anti-Keynesian (except in 2007)– President Barack Obama, used Keynesian

economics through government stimulus programs to attempt to assist the economic state.

Keynesian Economics

PriceLevel

Output

AD1AD2

Y2

Aggregate Supply and DemandClassical, Keynesian, and NeoClassical Models

PriceLevel

Output

AD1AD2

Y1Y2

Output

AD1Y1

PriceLevel

Classical Economics

Keynesian Economics

Keynesian Economics

Neoclassical Economics

Classical

Intermediate (short-run)

Keynesian

• Multiplier effect – additional shifts in AD that result when expansionary fiscal policy increases income, which leads to consumer spending

• Investment accelerator – positive response to the increase in aggregate demand leads to capital deepening

Multiplier Effect

50

Pricelevel

Quantity of Output

Aggregate demand, AD1

AD2

AD3

$20 billion

1. An increase in government purchasesof $20 billion initially increases aggregatedemand by $20 billion . . .

2. . . . but the multipliereffect can amplify theshift in aggregatedemand.

Multiplier Effect

• Marginal Propensity to Consume (MPC) – fraction of extra income that a household consumes rather than saves– ¾ = household spends .75 and saves .25– ½ = household spends .50 and saves .50– ¼ = household spends .25 and saves .75

Marginal Propensity to Consume (MPC)

• Multiplier = 1/(1 – MPC)– ¾ (.75) MPC, MM = 1/(1-.75) = 4– Government spending is $20 billion– 20 Billion x 4 = $80 Billion

• if MPC = 0.5 multiplier = 2• if MPC = 0.75 multiplier = 4• if MPC = 0.9 multiplier = 10• A bigger MPC means changes in Y cause bigger

changes in C, which in turn causemore changes in Y.

Multiplier Formula

• Crowding-out effect – when expansionary fiscal policy increases AD, which in turn raises interest rates

• This “crowds out” potential capital investments by firms

• High interest rates are a deterrent to borrowing

Crowding-Out Effect

• Government cuts taxes or offers tax credits, increases households’ take-home pay

– Tax cuts/credits shift AD to the right because “C” goes up– Multiplier effect can depend on the perception of tax permanence

(Bush Tax Cuts, Payroll Tax Cut vs. a one-time stimulus)• Raise taxes, decreases households’ take-home pay

– Tax hikes shift AD to the left because “C” goes down

Changes in Taxes

• Active policies by the FED and Federal Government to interrupt long-run trends in the short-run• Respond to changes in private economy to stabilize AD• Fed– Raise the money supply to offset reduction in spending– Increased money supply lowers interest rates• Federal Government– Cut taxes, offer tax credits– Increase spending

Active Stabilization Policy

• Automatic Stabilizers – “safety net”, changes in fiscal policy that stimulate AD when economy goes into a recession w/out policymakers having to take deliberate action– Progressive tax system, recession lowers taxes collected– Government discretionary spending increases during

recession (unemployment, welfare, other cash transfers)

Automatic Stabilizers

Tools of Fiscal Policy ChartFiscal Policy Expansionary/

ContractionaryExplanation

1. The government cuts business and personal income taxes and increases its own spending.

2. The government increases the personal income, Social Security and corporate income tax.

3. Government spending goes up while taxes remain the same.

4. The government reduces the wages of its employees while raising taxes on consumers and businesses.




Expansionary Decreased taxes increase C & I. Increase in government spending increases G.Shifts AD to the right.









Contractionary I & C decrease because of the tax increase.Shifts AD to the left.










Expansionary Higher government spending without a corresponding rise in tax receipts increases G.Shifts AD to the right.









Expansionary Higher government spending without a corresponding rise in tax receipts increases G.Shifts AD to the right.


Contractionary Reduction in government spending results in a decrease in aggregate demand.Increases in taxes reduces C.Increased business taxes reduce I.Shifts AD to the left.

Effects of Fiscal Policy ChartScenario Expansionary/

ContractionaryEffect on Federal Budget

Objective for Aggregate Demand

Action on Taxes

Action on Gov’tSpending

Effect on the National Debt

1. National unemployment rate rises to 12%

2. Inflation is strong at a rate of 14% per year.

3. Surveys show consumers are losing confidence in the economy, retail sales are weak and business inventories are increasing rapidly

4. Business sales and investment are expanding rapidly, and economists think strong inflation lies ahead.

5. The government eliminates the deductibility of interest expense for tax purposes

Expansionary

Contractionary

Expansionary

Contractionary

Move toward a deficit

Move toward a surplus

Move toward a deficit

Move toward a surplus

ContractionaryMove toward a surplus

Scenario 1: Your economy is experiencing an economic recession as a result of a lack of spending.

Assume long-run equilibrium initiallyShow your economy from long-run to the recession on the LRAS model.Show your economy in the recession using a PPC model.


Explain in words what will happen if policymaker’s take no corrective action (automatic stabilization) and allow the economy to self adjust.

Show how your economy will self-correct on the LRAS model.


Explain in words what both the Federal Reserve and the Federal Government could do to stimulate the economy and get the economy back to long-run equilibrium.

Show a graph of the LRAS with active stabilization measuresShow a graph of the Money Market with your active stabilization measures.


Assume that the federal government had to run a budget deficit to increase AD. Draw a properly labeled graph of the loanable funds market to show the government running a budget deficit

Scenario 2: Your economy is experiencing an economic boom. You are faced with an overheated economy as a

result of an increase in consumer spending.

Assume long-run equilibrium initiallyShow your economy from long-run to the boom on the LRAS model.


result of an increase in consumer spending.Explain in words what both the Federal Reserve and the Federal Government could do to slow the economy and get the economy back to long-run equilibrium.



result of an increase in consumer spending.Assume that the federal government is running a budget surplus as a result of the increase consumer spending.

Draw a properly labeled graph of the loanable funds market to show the government running a budget surplus.

Scenario 3: Your economy is experiencing a positive short-run supply shock. OPEC lowered the cost of oil for one year to ease international tensions. You are faced with an overheated economy as a result of the lower input costs.



Explain in words what will happen if policymaker’s take no corrective action (automatic stabilization) and allow the economy to self adjust.Show how your economy will self-correct on the LRAS model.


Explain in words what both the Federal Reserve and the Federal Government could do to slow the economy and get the economy back to long-run equilibrium.

Show a graph of the LRAS with active stabilization measuresShow a graph of the Money Market with your active stabilization measures..


Assume that the short-run supply shock allows your economy to produce beyond the PPF. Show this on the PPC model.

.

Scenario 4: Your economy is experiencing a positive long-run supply shock. Immigration restrictions are lifted and cause a massive wave of immigration.

You are faced with an overheated economy as a result of the lower input costs.

Assume long-run equilibrium initiallyShow your economy from initial long-run to the new long-run, on the LRAS model, as a result of the immigration.Show your structural economic change using a PPC model.Show the LRAS curve in the new equilibrium, with a shift to the right in AD as a result of reduced input costs.

Scenario 5: Your economy is experiencing a negative long-run supply shock. Immigration restrictions are raised and cause a massive wave of emigration. You are faced with an

structural change in the economy as a result of the higher input costs (people can demand higher wages because of the shortage of workers).

Assume long-run equilibrium initiallyShow your economy from initial long-run to the new long-run, on the LRAS model, as a result of the immigration.Show your structural economic change using a PPC model.



Explain in words what both the Federal Reserve and the Federal Government could do to increase AD and get unemployment down (back to normal rate of 5-6%)




Assume that the federal government is running a budget surplus as a result of the increase consumer spending.


Scenario 6: Your economy is experiencing a negative short-run supply shock. War in the Middle East causes the cost of oil to increase for one year. You are faced with an

underperforming economy as a result of the higher input costs.

Assume long-run equilibrium initiallyShow your economy in the supply shock on the LRAS model.Show your underperforming economy using a PPC model.

Scenario 7: Your economy is experiencing a positive long-run supply shock. Technological advances are causing major reductions in input costs for firms. You are

faced with an overheated economy as a result of the lower input costs.

Assume long-run equilibrium initiallyShow your economy from initial long-run to the new long-run, on the LRAS model, as a result of the technology.Show your structural economic change using a PPC model.Show the LRAS curve in the new equilibrium, with a shift to the right in AD as a result of reduced input costs.

Scenario 8: Your economy is experiencing tremendous consumer confidence and the marginal propensity to consume has risen. You are faced with an overheated economy

as a result of an increase in consumer and business spending.




Assume that the federal government is running a budget surplus as a result of the increase consumer spending.


Chapter 34 Practice Worksheet1. If a country’s central bank were to engage in activist stabilization policy, in which direction should it move the money supply in response to the following events?a.A wave of optimism boosts business investment and household consumption.

• Decrease the money supplyb.To balance its budget, the government raises taxes and reduces expenditures.

• Increase the money supplya. OPEC raises the price of crude oil.• Increase the money supplyb. The taste for the country’s products amongst the residents of other

countries declines.• Increase the money supplya. The stock market falls.• Increase the money supply

Chapter 34 Practice Worksheet

2. If a country’s central bank were to engage in activist stabilization policy, in which direction should it move interest rates in response to the same events listed in the previous question?

a. A wave of optimism boosts business investment and household consumption• Increase interest ratesb. To balance its budget, the government raises taxes and reduces

expenditures.• Decrease interest ratesc. OPEC raises the price of crude oil.• Decrease interest ratesd. The taste for the country’s products amongst the residents of other

countries declines.• Decrease interest ratese. The stock market falls.• Decrease interest ratesf. Explain the relationship between central bank policy in terms of the money

supply and policy in terms of the interest rate.• In the short run, with prices sticky or fixed, an increase in the money supply implies a

reduction in interest rates and a decrease in the money supply implies an increase in interest rates.

Chapter 34 Practice Worksheet3. If policy makers were to use fiscal policy to actively stabilize the

economy, in which direction should they move government spending and taxes?

a. A wave of pessimism reduces business investment and household consumption.

• Increase spending, decrease taxes

b. An increase in price expectations causes unions to demand higher wages.

• Decrease spending, increase taxesc. The taste for the country’s products amongst the residents of other

countries declines.• Increase spending, decrease taxesd. OPEC raises the price of crude oil.• Increase spending, decrease taxes

Chapter 34 Practice Worksheet4. a. Multiplier = 1/(1 – 0.75) = 4; $100/4 = $25 billion.b. Multiplier = 1/(1 – 0.80) = 5; $100/5 = $20 billion.c. More, because as the government spends more, investors spend

less so aggregate demand won’t increase by as much as the multiplier suggests.

d. More of a problem. Government spending raises interest rates. The more sensitive investment is to the interest rate, the more it is reduced or crowded out by government spending.

e. More likely to allow the economy to adjust on its own because if the economy adjusts beforethe impact of the fiscal policy is felt, the fiscal policy will be destabilizing.

Chapter 34 Practice Worksheet

5. a. It lowers interest rates because, in the short run, with prices sticky

or fixed, money demand is unchanging. Thus, an increase in the money supply requires a decrease in interest rates to induce people to hold the additional money.

b. It has no effect because, in the long run, the increase in spending causes a proportional increase in prices, output is fixed at the natural rate, money is neutral, and interest rates are determined by the supply and demand for loanable funds which have not changed.

Extra Credit1. Describe the difference between monetary and fiscal policy.2. Fill out the chart to indicate the measures the Federal Government could take

to deal with the scenarios below.

Scenario Expansionary/ Contractionary

Effect on Federal Budget

Objective for Aggregate Demand

Action on Taxes

Action on Gov’tSpending

Effect on the National Debt

1. The stock market is booming

2. The economy is experiencing deflation

Chapter 34 – The Influence of Monetary and Fiscal Policy on Aggregate Demand

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Transcript of Chapter 34 – The Influence of Monetary and Fiscal Policy on Aggregate Demand