ECON 1BB3 Chapter Notes - Chapter 15: Unemployment, Fixed Exchange-Rate System, Fiscal Policy

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14- Influence of Monetary and Fiscal Policies on Aggregate Demand
Changes in Money Supply via Monetary Policies *want to shift AD so Y = Y^ by changing I
IN A CLOSED ECONOMY
Monetary policies (changes in money supply) can affect AD
- Monetary injection = increase money supply
o Shift MS to the right, resulting in a decrease in interest rate (induce
people to hold onto additional money ie. not invest or save)
o With people holding onto money, this encourages them to buy more
houses or capital and equipment (ie. demand money for residential
and business investment), thus AD and ultimately MD shifts right,
raising the interest rate slightly higher.
- Monetary contraction = decerase money supply
o Shift MS shfits left, causing a rise in the interest rate, resulting in
people saving and investing more, so there is a decrease in money
demanded and MD shifts right
IN AN OPEN MARKET
Recall: since Canada is a perfect capital mobility, our interest rate chances with the
world interest rates
- Monetary injection = increase money supply
o Shift MS to the right, making r fall below the world interest rate.
So, Canadians are induced to hold onto their money (no saving
or investing). The lower interest rates stimulate people to want
to invest more so MD shifts right and r rises slightly.
o But r is less than world interest rate, so to return…
To return to world interest rate:
Flexible exchange rate- allowance that exchange rate changes freely
- Lower interest rates make our assets less attractive so foreigners sell
Canadian assets and buy foreign assets. To do they, they have to sell CAD dollars and buy foreign currency, thus CAD dollars in
foreign currency market increase, making the dollar depreciate. This makes out G/S less expensive than the world so our net
exports increase causing an increase in demand for G/S at every price point. This demand for our money shifts MD to the right so
that our interest rate is at world’s interest rate.
*Increase money supply, depreciates dollar value, causing increase in net exports and increase in MD to the right, more than in a closed
economy.
Fixed exchange rate- the exchange rate is fixed by the central bank
- The BoC cannot simultaneously choose the size of the money supply and the value of the CAD dollar
Influence of Fiscal Policies *shift AD so Y = Y^ by changing G and C
Fiscal policy- regulating spending and taxation by the government
If the gov’t chooses to introduce a $5 bill job creation program, then AD
for new roads, sewers… will increase, causing a shift in AD. But by how much?
The Multiplier Effect => push AD greater than gov’t spending
Higher demand by the government causes an increase in employment
and increase in profits for employers, so overall, an increase in income. This
causes an increase in consumer spending. Thus, for every dollar spent by the
government, raises the AD for more than a dollar. This is a positive feedback as
more demand, results in increase profit and increased income = investment
accelerator.
MPC = marginal propensity of consumption- a fraction of income a consumer
spends and not saves. Ex. for 1 dollar, they save ¾, and spend ¼
- Larger MPC means a larger multiplier
MPI= marginal propensity of import
- Larger MPI means smaller multiplier
CLOSED ECONOMY: Multiplier = 1/ (1 MPC)
OPEN ECONOMY: Multiplier = 1/ (1 MPC + MPI)
Crowding-Out Effect on Investment => push AD less than gov’t soending
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