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ECN204 Ch15 Notes.docx

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ECN 204
Christos Shiamptanis

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 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  Shifts AD right - Contractionary fiscal policy  Decrease in G and/or increase in T  Shifts AD left - 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  Multiplier effect: additional shifts in AD that result when fiscal policy increase income and thereby increases consumer spending - $20b increase in G initially shifts AD to right by $20b - Increase Y causes C to rise, which shifts AD further to the right Marginal Propensity to Consumer - How big is the multiplier effect?  Depends on how much consumers respond to increase in incomes - Marginal propensity to consumer(MPC):  Fraction of extra income that households consumer rather than save e.g. if MPC = 0.8 and income rises $100, C rises $80 Formula for the Multiplier - Size of multiplier depends on MPC E.g. MPC = 0.5  multiplier = 2 MPC = 0.75 multiplier = 4 MPC = 0.9  multiplier = 10 - Bigger MPC means changes in Y cause bigger changes in C, which in turn cause more changes in Y Other Applications of Multiplier Effect - Multiplier effect:  Each $1 increase in G can generate more than a $1 increase in aggregate demand - Also true for other components of GDP Example: Suppose a recession overseas reduces demand for Canadian net exports by $10b Initially, aggregate demand falls by $10b Fall in Y causes C
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