# ECN 204 Lecture Notes - Exchange Rate, Tax Cut, Unemployment Benefits

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22 Oct 2012
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ECN204 Ch15 Notes
Influence of Monetary and Fiscal Policy on Aggregate Demand
Introduction
- Short-run effects of fiscal and monetary policy, which work through aggregate demand
Aggregate Demand
- Recall, AD curve slopes downward for three reason:
Wealth effect
Interest-rate effect most important of these effects for the economy
- Next
Study model that helps explain the interest-rate effect and how monetary policy affects aggregate demand
Theory of Liquidity Preference
- Simple theory of the interest rate (denoted r)
- R adjusts to balance supply and demand for money
- Money supply: assume fixed by central bank, 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:
Money liquid buy pays no interest
Bonds pay interest but not as liquid
- A household’s “money demand” reflects its preference for liquidity
- Variables that influence money demand: Y, r, and P
Money Demand
- Suppose real income (Y) rises. Other things equal, what happens to money demand?
- If Y rises:
Households want to buy more good & service, so they need more money
To get this money, they attempt to sell some of their bonds
- i.e., an increase in causes an increase in money demand, other things equal
Active Learning 1
a. Suppose r rises. Other things equal, what happens to money demand?
R is the opportunity cost of holding money
Increase in r reduces money demand:
Households attempt to buy bonds to take advantage of the higher interest rate
Hence, increase in r causes a decrease in money demand, other things equal
b. Suppose P rises. Other things equal, what happens to money demand?
Y is unchanged, people will want to buy the same amount of Good & Service
Since P is higher, they will need more money to do so
Hence, increase in P causes an increase in money demand, other things equal
How r is Determined
- MS curve is vertical:
Changes in r do not affect MS, fixed by BoC
- MD curve is downward sloping:
Fall in r increases money demand
How Interest-Rate Effect Works
Monetary Policy and Aggregate Demand
- To Achieve macroeconomic goals, the BoC can use monetary policy to shift AD curve
- BoC can change money supply by buying and selling government bonds by conducting open market operations
- Changes the interest rate and shift Ad curve
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Effects of Reducing Money Supply: Closed Economy
Active Learning 2
- Determine short-run effects on output
- Determine how BoC should adjust money supply and interest rates to stabilize output
a. Minister of Finance tries to balance the budget by cutting government spending
Event would reduce aggregate demand and output
Offset this event, the BoC should increase MS and reduce r to increase aggregate demand
b. Stock market boom increases household wealth
Event would increase aggregate demand, raising output above its natural rate
Offset this event, the BoC should reduce MS and increase r to reduce aggregate demand
c. War breaks out in the Middle East, causing oil prices to soar
Event would reduce aggregate supply, causing output fall
Offset this event, the BoC should increase MS and reduce r to increase aggregate demand
Open Economy Considerations
- Monetary injection by BoC
Causes dollar to depreciate in value
Dollar depreciation causes net exports to rise
Additional increase in demand for Canadian-produced goods and services not realized in closed economy
Monetary injection in an open economy shifts the aggregate-demand curve farter to the right than in a closed
economy
BoC cannot simultaneously choose the size of the money supply and the value of Canadian dollar
Monetary Injection in an Open Economy
Fiscal Policy and Aggregate Demand
- Fiscal policy: setting of the level of government spending and taxation by government policymakers
- Expansionary fiscal policy
Increase in G and/or decrease in T
- Contractionary fiscal policy
Decrease in G and/or increase in T
- Fiscal policy has two effects on AD
1. Multiplier Effect
- If government buys \$20B of planes from Boeing, Boeing’s revenue increase by \$20b
- This distributed to Boeing’s workers (as wages) and owners (as profits or stock dividends)
- People are also consumers and will spend a portion of the extra income
- Extra consumption cause further increase in aggregate demand
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