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ECON 1B03 (303)
Chapter 15

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Department
Economics
Course
ECON 1B03
Professor
Bridget O' Shaughnessy
Semester
Fall

Description
Chapter 15 How monetary Policy Influences Aggregate Demand - The wealth effect, the interest-rate effect and the real exchange-rate effect should not be viewed as alternative theories, but occur simultaneously to increase the quantity of goods and services demanded - But, are not of equal importance… wealth effect is least important and interest rate effect is most important (real-exchange rate is non-existent in a closed economy) - Theory of liquidity preference: Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance The Theory of Liquidity - economists distinguish between two interest rates o nominal interest rate: the interest rate as usually reported o real interest rate: the interest rate corrected for the effects of inflation - liquidity preference tries to explain both interest rates Money Supply - first piece of the theory of liquidity preference is the supply of money - The Bank of Canada alters the money supply using two methods o Changing the quantity of reserves in the banking system …open-market operations and foreign exchange market operations o Changing the bank rate—the interest rate on loans that the Bank of Canada makes to commercial banks - Open market operations and changing the bank rate are the most important methods used by the Bank of Canada for changing the money supply - We assume that the supply of money is not affected at all by changes in the interest rate and therefor the money-supply curve is a vertical line Money Demand - second piece of the theory of liquidity preference is the demand for money - assets’ liquidity refers to the ease with which that asset is converted into the economy’s medium of exchange - interest rate is the opportunity cost of holding money - an increase in the interest rate raises the cost of holding money ….a decrease in the interest rate reduces the cost of holding money .. therefor the money-demand curve slopes downward the price level in the economy is represented by a price index such as the consumer price index(CPI) or the GDP deflator - an increase in the dollar value of transactions causes the demand for money to increase shifting the money- demand curve right - a decrease in the dollar value of transactions causes the demand for money to decrease, shifting the money- demand curve left Equilibrium in the Money Market - the interest rate adjusts to balance the supply and demand for money - people try to keep the interest rate at the equilibrium interest rate(the quantity of money demanded exactly balances quantity of money supplied The Downward Slope of the Aggregate-Demand Curve - an increase in money demanded raises the interest rate, to discourage people from trying to hold on to money - the higher interest rate - 1. A higher price level raises money demand - 2. Higher money demand leads to a higher interest rate - 3. A higher interest rate reduces the quantity of goods and services demanded - Could be used in reverse as well… a lower price level reduces money demanded, which leads to a lower interest rate and this in turn increases the quantity of goods and services demanded - A negative relationship between the price level and the quantity of goods and services demanded is illustrated with a downward-sloping aggregate-demand curve - In an open economy the other important influence is the real exchange-rate effect - Increase in price level causes the real exchange rate to increase - This makes Canadian goods more expensive relative to foreign-produced goods so both foreigners and Canadians substitute away from Canadian-produced goods - Canada’s net exports fall - In a small open economy an increase in the price level causes the quantity of Canadian-produced goods and services demanded to fall - Whether due to the interest rate effect or real exchange-rate effect the end result is a negative relationship between the price level and the quantity of goods and services demanded - This relationship is illustrated by a downward sloping aggregate-demand curve Changes in the Money Supply - One important variable that shifts the aggregate-demand curve is monetary policy - To see how monetary policy effects the economy in the short run suppose the bank of Canada increases the money supply by buying government bonds in open-market operations - Consider how monetary injection influences the equilibrium interest rate for a given price level. That will tell you what the injection does to the position of the aggregate-demand curve - Increase in money supply shifts curve from MS1 to MS2 - Because money-demand curve has not changed the interest rate falls from r1 to r2 to balance money supply and money demand - Interest rate must fall to induce people to hold additional money the bank of Canada has created - Interest rate influences the quantity of goods and services demanded - Lower interest rates reduce the cost of borrowing and return to saving - Households buy more and larger houses, stimulating the demand for residential investment - Firms spend more on new factories and equipment stimulating business investment for all these reasons the quantity of goods and services demanded at the given price level 1/P rises - Increase demand for goods and services increases the demand for money, MD1 to MD2 - Interest rate rises slightly from r2 to r3 - Partial reversal in the fall of interest rate reduces somewhat the simulative effect on residential and firm investment - Shift in aggregate demand is smaller - Net effect is an increase in the quantity of goods and services demanded at the given price level 1/P from Y1 to Y2 - Shift to the right of the aggregate-demand curve from AD1 to AD2 - Of course there is nothing special about 1/P: the monetary injection raises the quantity of goods and services demanded at every price level - The entire aggregate-demand curve is shifted to the right - When the bank of Canada increases the money supply it lowers the interest rate and increases the quantity of goods and services demanded for any given price level o This shifts the aggregate-demand curve to the right. - When the bank of Canada contracts the money supply it raises the interest rate and reduces the quantity of goods and services demanded for and price level - This shifts the aggregate-demand curve to the left. Open-Economy Considerations - For a given price level, the aggregate-demand curve shifts - Increase in money supply shifts curve to the right - Because money demand curve has not changed the interest rate falls below the world interest rate in order to balance money supply and money demand - Canadian interest rate must fall to induce people to hold the additional money the bank of Canada has created - Interest rate influences the quantity of goods and services demanded - By lowering the cost of borrowing and the return to saving, the lower interest rate stimulates the demand for residential and business investment - The quantity of goods and services demanded at the given price level 1/P rises - Increase in output increases demand for money from MD1 to MD2 causing interest rate to rise from r2 to r3 - This fall in interest rate reduces simulative effect on residential and firm investment - The increase in demand for goods and services is smaller - Net effect is a shift in aggregate-demand curve from AD1 to AD2 and an increase in quantity of goods and services demanded from Y1 to Y2 - Because of perfect capital mobility Canada’s interest rate must eventually adjust to equal world interest rate - Canada’s interest rate falls below world interest rate, Canadian and foreign savers find canadas assets , which now pay interest rate r3, less attractive than foreign assets that pay world interest rate - Canadians and foreigners sell Canadian assets and buy foreign assets - The switch from Canadian assets to foreign ones requires a corresponding sale of Canadian dollars and purchase of foreign currencies - In the market for foreign currency exchange the supply of Canadian dollars increases causing the dollar to depreciate in value and the real exchange rate to fall - Fall in real exchange rate males Canadian produced goods and services less expensive relative to foreign ones - Canada’s net exports increase causing the quantity of goods and services demanded at given price level 1/P to increase further - Shift aggregate-demand curve from AD2 to AD3 - Increase in output increases demand for money which causes interest rate to rise further - Shift money demand curve from MD2 to MD3 - Shift must cause Canada’s interest rate to once again equal world interest rate - End result is increase in demand for money to MD3, a return to Canada’s interest rate to world interest rate and increase in quantity of goods and services demanded to Y3 and shift in aggregate-demand curve to AD3 - In a small open economy a monetary injection by the bank of Canada causes the dollar to depreciate in value o Because this depreciation of the dollar causes net exports to rise there is an additional increase in demand for Canadian produced goods and services that is not realized in a closed economy o In the end, a monetary injection in an open economy shifts the aggregate-demand curve farther to the right than it does in a closed economy. - By lowering Canadian interest rate, monetary injection causes Canadians and foreigners to sell Canadian assets and switch to foreign assets.. which increases Canadian dollars in the foreign exchange market.. which causes the exchange rate to fall - Bank of Canada cannot simultaneously choose the size of the money supply and the value of the Canadian dollar Changes in Government Purchases - When policymakers change the money supply or the level of taxes, they shift aggregate-demand curve by influencing the spending decisions of firms or households. - When government alters its own purchases of goods and services, its shifts aggregate-demand curve directly - Ex. Federal government introduces $5 billion job-creation program - For given price level the program will finance new roads, sewers and bridges - Program raises the demand for construction work and induces construction firms to hire more - Increase in construction work increases aggregate demand for goods and services - Aggregate demand curve shifts right - Aggregate-demand curve does not shift to the right by $5 billion like you might assume - there are two macroeconomic effects that dictate the shift - first is the multiplier effect – suggests that the shift in aggregate-demand could be larger than $5 billion - second is the crowding-out effect – suggests that the shift in aggregate demand could be smaller than $5 billion The Multiplier Effect - when government spends $5 billion on construction it has repercussions - for given price level the immediate impact of the higher demand from the government is to raise employment and profits for the construction firms involved - as workers see higher earnings and firms see higher profits they spend on consumer goods - As a result the $5 billion raises the demand for the products of other firms in the economy - Because each dollar spent by government can raise aggregate demand for goods and services by more than a dollar government purchases are said to have a multiplier effect of aggregate demand - Multiplier effect continues
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