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ECON1000 CH. 15.docx

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Carleton University
ECON 1000
Nick Rowe

Chapter 15: The Influence of Monetary and Fiscal Policy on Aggregate Demand Introduction •Earlier chapters covered: o The long-run effects of fiscal policy on interest rates, investments and economic growth o The long-run effects of monetary policy on the price level and inflation rate •This chapter focuses on the short run effects of fiscal and monetary policy, which work through aggregate demand Aggregate Demand Recall the AD curve slopes downward for three reasons •The wealth effect •The interest-rate effect •The exchange rate effect (most important in Canadian economy) The Theory of Liquidity Preference •Keynes developed the theory of liquidity preference in order to explain what factors determine the economy's interest rate •R adjusts to balance supply and demand for money •Money supply: assumed fixed by BOC o Open market operations o Changing the bank rate •Does not depend on interest rate •Money demand reflects how much wealth people want to hold in liquid form •For simplicity, suppose household wealth includes only two assets: o Money: liquid but pays no interest o Bonds: pay interest but not as liquid •A household's "money demand" reflects its preference for liquidity •The variables that influence money demand: o Y, r and P Money Demand •Suppose real income (Y) rises. Other things equal, what happens to money demand? •If Y rises: o Households want to buy more goods and services so they need more money o To get this money, they attempt to sell some of their bonds •i.e. an increase in Y causes an increase in money demand, other things equal Questions: The Determinants of Money Demand Q: Suppose r rises, but Y and P are unchanged. What happens to money demand? •R is the opportunity cost of holding money. An increase in r reduces money demand. Households attempt to buy bonds to take advantage of the higher interest rate. •Hence, an increase in r causes a decrease in money demand, other things equal. Q: Suppose P rises, but Y and r are unchanged. What happens to money demand? •If Y is unchanged, people will want to buy the same amount of goods and services. Since P is higher, they will need more money to do so. •Hence, an increase in P causes an increase in money demand, other things equal The Theory of Liquidity Preference Equilibrium in the Money Market • Assume the following about the economy: o The price level is stuck at some level o For any given price level, the interest rate adjusts to balance the supply and demand for money o The level of output responds to the aggregate demand for goods and services How r is Determined The Downward Slope of the Aggregate Demand Curve • The price level is one determinant of the quantity of money demanded • A higher price level increases the quantity of money demanded for any given interest rate • Higher money demand leads to a higher interest rate • The quantity of goods and services demanded falls • In an open economy, the other important influence is the real exchange rate effect o An increase in the price level causes the real exchange rate to increase o Canadian produced goods are more expensive relative to foreign produced goods, both foreigners and Canadians substitute away from Canadian produced goods o Canada's net exports fall • The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded How the Interest-Rate Effect Works Monetary Policy and Aggregate Demand When the Bank of Canada: •Increases the money supply, the interest rate falls and increases the quantity of goods and services demanded for any given price level, increasing aggregate demand •Contracts the money supply, the interest rate rises, reduces the quantity of goods and services demanded and lowers aggregate demand The Effects of Reducing the Money Supply: Closed Economy Questions: For each of these events, determine the short run effects on output, determine how the BOC should adjust the money supply and interest rates to stabilize output Q: The Minister of Finance tries to balance the budget by cutting government spending. •This event would reduce aggregate demand and output. To offset this event, the BOC should increase money supply (MS) and reduce r to increase aggregate demand Q: A stock market boom increases household wealth. • This event would increase aggregate demand, raising output above its natural rate. To offset this event, the BOC should reduce MS and increase r to reduce aggregate demand. Q: War breaks out in the Middle East, causing oil prices to soar. • This event would reduce aggregate supply, causing output to fall. To offset this event, the BOC should increase MS and reduce r to increase aggregate demand Open Economy Considerations A monetary injection by the Bank of Canada • Causes the dollar to depreciate in value • The dollar depreciation cuases net exports to rise • An additional increase in demand for Canadian-produced goods and services not realized in a closed economy • In the end, a monetary injection in an open economy shifts the aggregate demand curve farther to the right than in a closed economy The Bank of Canada cannot simultaneously choose the size of the money supply and the value of the Canadian dollar. Fiscal Policy and Aggregate Demand Fiscal policy • The setting of the level of govrenment spending and taxation by government policymakers Expansionary Fiscal Policy • An increase in G and/or decrease in T • Shifts AD right Contractionary Fiscal Policy • A decrease in G and/or increase in T • Shifts AD left Fiscal Policy has two effects on AD: • Multiplier Effect • Crowding out Effect The Multiplier Effect • If the government buys $20b of planes from Boeing, Boeing's revenue increases by $20b • This is distributed to Boeing's workers (as wages) and owners (as profits or stock dividends) • These people are also consumers, and will spend a portion of the extra income • This extra consumption causes futher increases in aggregate demand • Multiplier Effect: o The additional shifts in AD that result when fiscal policy increases income and thereby increases consumer spending The Multiplier Effect: Marginal Propensity to Consume • How big is the multiplier effect? o It depends on how much consumers respond to increases in income • Marginal Propensity to Consume (MPC): o The fraction of extra income that households consume rather than save • E.g. if MPC = 0.8 and income rises $100 o C rises $80 A Formula for the Multiplier (see sheet for nicer copy) Y = C + I + G + NX Change in Y = Change in C + Change in G Change in Y = (MPC)(Change in Y) + Change in G Change in Y = (1/1 - MPC)(change in G) The size of the multiplier depends on MPC • E.g. 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 cause more changes in Y. Other Applications of the Multiplier Effect • The multiplier effect: o Each $1.00 increase in G can generate more than a $1.00 increase in aggregate demand • Also true for the other components of GDP: o Ex. Suppose a recession overseas reduces demand for US exports by $10b o Intially, aggregate demand falls by $10b o The fall in Y causes C to fall as well, which further reduces aggregate
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