Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Eleven Monetary Policy and Fiscal...

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


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


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.


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

][

)/(


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.


Chapter 11.2 7


(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).


Chapter 11.2 8


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.


Chapter 11.2 9


P

Y1

AD0

P0

Real GDP

Y0

(d) Aggregate Demand

Y2

P1

P2

Changes in P cause movements along AD


Chapter 11.3 10

Short-Run Equilibrium Output and Price

P

AD0

P0

Real GDP

Y0

AS0

Pric

e Le

vel


Chapter 11.3 11


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


Chapter 11.3 12


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


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


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


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


Chapter 11.4 16

(b) The Government Budget


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.


Chapter 11.4 17


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


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


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.


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


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


Chapter 11.5 22


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)


Chapter 11.5 23


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


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


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


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.


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.

Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Eleven Monetary Policy and Fiscal...

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