ECMA06 – Stabilization Policy & The Introduction of Open Economy 1
Stabilization Policy & The Introduction of Open Economy
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
MS r I AE & AD Y
To decrease output the central bank runs contractionary
MS r I AE & AD Y
Question: Is there a limit on the use of monetary policy to affect
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
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
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
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
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.
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 )
Option 1 – Main status tain the Status Quo
AE Y = AE 0
Y FE 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 )
** 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
0 A A’
L(r, Y ) I(r)
M 0 I
MS I ECMA06 – Stabilization Policy & The Introduction of Open Economy 11
Although the in I will Y, it only partially offsets the initial
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