Lecture notes for week 10

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University of Toronto Scarborough
Economics for Management Studies
Iris Au

STABILIZATION POLICY & THE INTRODUCTION OF OPEN ECONOMY Outline N Discuss the effectiveness of monetary policy in affecting output. N Compare how fiscal & monetary policies affect AD. N Use of fiscal & monetary policies to smooth out business cycles. N Discuss issues related to stabilization policy such as the crowding out effect and national debt. N Introduce open economy in our modeldiscuss the countrys balance of payments. Does Monetary Policy Always Work? N Monetary policy could be used to affect output: o To increase output the central bank should run expansionary monetary policy. o To decrease output the central bank should run contractionary monetary policy. N Question: Does monetary policy always work (i.e., could it be used to affect output)? N Answer: Yes if the links hold up. o For example, when MS increases, interest rate decreases. o This decrease in interest rate would stimulate (physical) investment if firms and households were willing to invest. o Investment increases AE increases AD increases Y increases. N However, if the economy is a severe recession, the above process would fail and the economy may be in a liquidity trap. N A liquidity trap is a situation in which the interest rate is extremely low (close to zero) such that monetary policy is no longer effective (i.e., could not be used to affect output). N Question: Do we witness any liquidity trap? N Answer: Yes, it could happen during major recessions. Examples include the US in the 1930s, Japan in the 1990s. The US in the present? Would Canada have one in the near future? N Lets take a look at how this works. N Recall, the link between MS and AD is indirect. It works through the change in interest rate and then the change in investment. I increases AD increases Y increases N However, if the interest rate is already close to zero, then a change in MS will have no effect on interest rate. Why? o Nominal interest rate CANNOT b1 negati2e! If MS increases from MS to MS , r does not change. If r is held fixed I does not change (I remains at I ). If I does not change AE is fixed AD is fixed Y is fixed. (Production & AD will be trapped at low levels) Comparison Between Monetary Policy and Fiscal PolicyHow Fiscal and Monetary Policies Affect Aggregate Demand N Fiscal policythe governments choice regarding levels of spending, taxes, and transfers. N Monetary policythe central banks choice regarding money supply. N Both fiscal and monetary policies are, sometimes, referred to as stabilization policy policy aimed at reducing the fluctuations in output in the short run. (Keep Y close to Y FE Expansionary Fiscal Policy N This includes G increases, T decreases, or TR increases. N An increase in G simulated AD directly since G enters the AE and AD functions directly. N A decrease in T or an increase in TR affects ADdirectly. o A decrease in T or an increase in TR increases DI (DI = Y T + TR). o DI increases C increases AE and AD increase Y increases. Expansionary Monetary PolicyOpen Market Purchase N The central bank buys bonds MS increases r decreases I increases AE and AD increase Y increases. N However, how much MS would increase depends on the loan creation process of commercial banks. o When central bank buys bonds, commercial banks find themselves have excess reserves they try to get rid of these excess reserves by making loans. o Given MS = reserves (1 reserve ratio), the ultimate change in MS depends on the reserve ratio. If the reserve ratio (rr) is high, then 1rr will be low change in MS will be small. www.notesolution.com
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