STABILIZATION POLICY & THE INTRODUCTION OF OPEN ECONOMY
x Discuss the effectiveness of monetary policy in affecting output.
x Compare how fiscal & monetary policies affect AD.
x Use of fiscal & monetary policies to smooth out business cycles.
x Discuss issues related to stabilization policy such as the crowding out effect and national debt.
x Introduce open economy in our model—discuss the country’s balance of payments.
Does Monetary Policy Always Work?
x 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.
x Question: Does monetary policy always work (i.e., could it be used to affect output)?
x 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 Æ AE increases Æ AD increases Æ Y increases.
x However, if the economy is a severe recession, the above process would fail and the economy may be in a liquidity trap.
x 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).
x Question: Do we witness any liquidity trap?
x 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?
x Let’s take a look at how this works.
x Recall, the link between MS and AD is indirect. It works through the change in interest rate and then the change in investment.
Æ I increases Æ AD increases Æ Y increases
x 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 be negative!
If MS increases from MS1 to MS2, r does not change.
If r is held fixed Æ I does not change (I remains at I1).
If I does not change Æ AE is fixed Æ AD is fixed Æ Y is fixed.
(Production & AD will be “trapped” at low levels)
Comparison Between Monetary Policy and Fiscal Policy—How Fiscal and Monetary Policies Affect Aggregate Demand
x Fiscal policy—the government’s choice regarding levels of spending, taxes, and transfers.
x Monetary policy—the central bank’s choice regarding money supply.
x Both fiscal and monetary policies are, sometimes, referred to as stabilization policy—public policy aimed at reducing the
fluctuations in output in the short run. (Keep Y close to YFE)
Expansionary Fiscal Policy
x This includes G increases, T decreases, or TR increases.
x An increase in G simulated AD directly since G enters the AE and AD functions directly.
x A decrease in T or an increase in TR affects AD indirectly.
o A decrease in T or an increase in TR increases DI (DI = Y – T + TR).
o DI increases Æ C increases Æ AE and AD increase Æ Y increases.
Expansionary Monetary Policy—Open Market Purchase
x The central bank buys bonds Æ MS increases Æ r decreases Æ I increases Æ AE and AD increase Æ Y increases.
x 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 Æ they try to “get rid of” these
excess reserves by making loans.
o Given ûMS = û reserves × (1 / reserve ratio), the ultimate change in MS depends on the reserve ratio.
If the reserve ratio (rr) is high, then 1/rr will be low Æ change in MS will be small.