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University of Toronto Scarborough
Economics for Management Studies
Iris Au

ECMA06 – Stabilization Policy & The Introduction of Open Economy 1 Stabilization Policy & The Introduction of Open Economy Outline  Discuss the effectiveness of monetary policy in affecting output.  Compare how fiscal & monetary policies affect AD.  Use of fiscal & monetary policies to smooth out business cycles.  Discuss issues related to stabilization policy such as the crowding out effect and national debt.  Introduce open economy in our model. ECMA06 – Stabilization Policy & The Introduction of Open Economy 2 Effectiveness of Monetary Policy  Monetary policy affects AD and Y through changes in r & I.  To increase output the central bank runs expansionary monetary policy: MS   r   I   AE  & AD   Y   To decrease output the central bank runs contractionary monetary policy. MS   r   I   AE  & AD   Y   Question: Is there a limit on the use of monetary policy to affect output?  Answer: Yes! The above processes work because we assume both firms and households are willing to adjust their investment plans when interest rate changes. If firms and households DO NOT respond to a change in interest rate – the economy may in a liquidity trap.  A liquidity trap is situation in which the interest rate is extremely low (close to zero) such that monetary policy is no longer effective. ECMA06 – Stabilization Policy & The Introduction of Open Economy 3 r MS 0 r r0 MD I(r) M I I0  If the interest rate is already close to zero, then a change in MS will have no effect on interest rate because  Nominal interest rate CANNOT be negative!  Question: Do we witness any liquidity trap?  Answer: Yes, examples include the U.S. in the 1930s, Japan in the 1990s. The U.S. in the present? ECMA06 – Stabilization Policy & The Introduction of Open Economy 4 Comparing How Fiscal and Monetary Policies Affect Aggregate Demand  Fiscal policy – the government’s choice regarding levels of spending, taxes, and transfers.  Monetary policy – the central bank’s choice regarding the level of money supply.  Both fiscal and monetary policies are, sometimes, referred as stabilization policy – public policies aimed at reducing the fluctuations in output in the short run (i.e., keeping Y close to Y FE How Expansionary Fiscal Policy Affects Output  Expansionary fiscal policy includes G , T , and/or TR .  An  in G simulates AD directly since G enters the AE and AD functions directly.  A  in T or an  in TR affects AD indirectly.  A  in T or an  in TR increases DI.  DI   C   AE and AD   Y . ECMA06 – Stabilization Policy & The Introduction of Open Economy 5 How Expansionary Monetary Policy Affects Output  The central bank carries open market purchase (MS )  r   I   both AE and AD   Y .  The effectiveness of this open market purchase depends on: 1)The loan creation process of chartered banks  When central bank buys bonds, chartered banks find themselves have excess reserves  they try to “get rid of” these excess reserves by making loans. 1 MS = CC + DD = CC + rr   reserves 2)How firms and households respond to the change in r:  If households and firms are not responsive to change in r, then investment will not change a lot  output will not change a lot. ECMA06 – Stabilization Policy & The Introduction of Open Economy 6 Stabilization Policy and Business Cycles  Use the linked diagram to compare and contrast two policy options when the short-run level of output is not the same as full-employment level of output (i.e., Y*  Y ). FE  The two policy options are:  Option 1: Maintain the status quo – Do nothing and let the economy corrects itself in the long run (via  in wages).  Option 2: Use fiscal or monetary policy – Adjust G, T, TR or MS to bring output back to Y in the short run. FE ECMA06 – Stabilization Policy & The Introduction of Open Economy Inflationary Gap (Y* > Y ) FE Option 1 – Main status tain the Status Quo AE Y = AE 0 AE(P ) A 45 Y Y FE Y* P 0 AS 0 P A’ AD Y Y FE Y*  Potential problem: The  in wages may make workers expect higher wages  if this wage expectation sets in, the economy may run into the risk of stagflation (we discussed it in Week 7). ECMA06 – Stabilization Policy & The Introduction of Open Economy Option 2 – Use Contractionary Fiscal or Monetary Policy AE Y = AE A AE(AE ,0P ) 45 Y Y Y* FE P AS P0 A” AD 0 Y YFE Y* ** You should know what happens if the economy is in a recessionary gap. ECMA06 – Stabilization Policy & The Introduction of Open Economy 9 The Role of Expectation & the Central Bank  In Week 7, we showed that the adjustment process in an inflationary gap leads to  in both wages & prices.  The problem is if people revise expectation (in this case, expect higher wages), the economy may get into the wage-price spiral. When workers demand higher wages, production cost increase – >AS shifts further to the left —> Price increase higher  The central bank can prevent the wage-price spiral by getting to the inflationary gap before expectation sets in.  The Bank of Canada sets an inflation target of 2%, and this target has extended to 2016.  By setting an inflation target, the Bank of Canada is sending signal to Canadians that inflation rate will be around 2% (the target range is 1% – 3%). If there is any indication that the inflation rate will deviate from the target, it will adjust MS to bring it back to the target level. ECMA06 – Stabilization Policy & The Introduction of Open Economy 10 Other Issues Related to Stabilization Policy Issue #1 – The Crowding Out Effect  Consider the feedback effect of a change in stabilization policy on the interest rate & investment. Example: Expansionary Fiscal Policy – An Increase in G r r 0 A A’ r L(r, Y ) I(r) M 0 I MS I ECMA06 – Stabilization Policy & The Introduction of Open Economy 11 Note:  Although the  in I will  Y, it only partially offsets the initial  1 in G on Y  we called this the crowding out effect.  Similar logic applies to monetary policy.  The subsequent change in I (due to a change in money
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