Harcourt Brace & Company Chapter 32 The Influence of Monetary and Fiscal Policy on Aggregate Demand.

Harcourt Brace & Company

Chapter 32

The Influence of Monetary and Fiscal Policy on Aggregate Demand


Economic Objectives

1. Full-N

2. Economic Growth

3. Price Stability


Two Problems in the Economy

Inflation

Unemployment


Inflationary Gap

Yf < Ye Normal market adjustment In the Long-run, the economy is

always at full-N


Recessionary Gap

Ye < Yf Normal Market adjustments In the Long-run, the economy is

always at full-N


Government Assistance

Monetary Policy Changing the Money Supply

and interest rates to achieve macroeconomic objectives by the Fed


The Supply and Demand for Money

The Money Demand is determined mostly by the interest rate.

“People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services.” (i.e. a desire of liquidity)


The Money MarketInterest

Rate

Quantity of Money

Money Demand

I0

Q0



Rate

Quantity of Money

Money Demand

I0

I1

Q0



Rate

Quantity of Money

Money Demand

I0

I1

Q1 Q0



The Money Supply is altered in three ways by the Fed:– Open-Market Operations

– Changing the Reserve Requirements

– Changing the Discount Rate The quantity of money is fixed by the

Fed.



Open-Market Operations can shift the Ms curve left or right.

If the Fed buys government bonds:– Bank reserves increase and the Ms

increases. If the Fed sells government bonds:

– Bank reserves decrease and the Ms decreases.



Rate

Quantity of Money

Money Supply

QFixed



Rate

Quantity of Money

Money Supply

QFixed

If the Fed buys government

bonds, money supply

increases.



Rate

Quantity of Money

Money Supply

QFixed

If the Fed sells government

bonds, money supply

decreases.


Equilibrium in the Money Market

By the Theory of Liquidity Preference:– The interest rate adjusts to balance the

supply and demand for money.

– There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded exactly equals the quantity of money supplied.


Equilibrium in the Money MarketInterest

Rate

Quantity of Money

Money Demand

Money Supply

QFixed

IE


Equilibrium in the Money MarketInterest

Rate

Quantity of Money

Money Demand

Money Supply

QFixed

IE

Money Supply andMoney Demand are

equal at the equilibriuminterest rate.


Changes in Money SupplyInterest

Rate

Quantity of Money

Money Demand

MS0

QFixed0

IE0



Rate

Quantity of Money

Money Demand

MS0

QFixed0

IE0

MS1



Rate

Quantity of Money

Money Demand

MS0

QFixed0

IE0

IE1

QFixed1

MS1


Closing an Inflationary Gapusing Monetary Policy

Ms falls, interest rates rise, and AD falls


Closing a Recessionary Gap using Monetary Policy

Ms rises, interest rate falls and AD rises


Discretionary Fiscal Policy

Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes to achieve macroeconomic objectives.


Using Policy to Stabilize the Economy

Those that accept discretionary fiscal policy as a means to attain short-run economic stabilization follow the Keynesian theory of the economy.


Federal Government Budget

The Federal government has the largest budget in the world - $1.7 billion.

General Motors, the largest corporation, has $165 billion.


Changes in Government Purchases

The federal government’s control of the economy is both direct and indirect.– Its expenditures have a direct effect on

aggregate spending and therefore equilibrium GDP.

– Taxes and tax policy indirectly affect the aggregate spending of consumers.


Closing an Inflationary Gap using Fiscal Policy

Government spending falls and/or taxes rise and AD falls.


Closing a Recessionary Gap using Fiscal Policy

Government spending rises and/or taxes fall and AD rises.


Changes in Government Purchases

There are two macroeconomic effects from government purchases:

– The Multiplier Effect

– The Crowding-Out Effect


The Multiplier Effect of Government Purchases

Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar--- a multiplier effect.


The Multiplier EffectPriceLevel

Quantity of Output

AD1



Quantity of Output

AD1 AD2

An increase in government

purchases initially increases AD



Quantity of Output

AD1 AD2

The multiplier effect can amplify the shift

in AD

AD3


The Multiplier Effect of Government Purchases

The formula for the multiplier is:

Multiplier = 1 ÷ (1 - MPC) the MPC is the Marginal Propensity to Consume.

MPC - how much of each additional dollar of income a household spends


The Crowding-Out Effect

An increase in government purchases causes the interest rate to rise, and a higher interest rate tends to choke off the demand for goods and services.

The reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.


Using Policy to Stabilize the Economy

Some economists argue that the government should avoid using monetary and fiscal policy to try to stabilize the economy. They suggest the economy should be left to deal with the short-run fluctuations on its own.

Discretionary Fiscal policy affects the economy with substantial lags.


Automatic Stabilizers

Automatic Stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

Automatic stabilizes include:– The Tax System

– Government Spending

Harcourt Brace & Company Chapter 32 The Influence of Monetary and Fiscal Policy on Aggregate Demand.

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