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Chapter 21

ECON 201 Chapter 21: Chapter21TheInfluenceofMonetaryandFiscalPolicyonAggregateDemand.pdf


Department
Economics
Course Code
ECON 201
Professor
Sarna
Chapter
21

Page:
of 4
Chapter21:TheInfluenceofMonetaryandFiscalPolicyonAggregateDemand
HowMonetaryPolicyInfluencesAggregateDemand
○ TheTheoryofLiquidityPreferenceKeynes’stheorythattheinterestrateadjuststobring
moneysupplyandmoneydemandintobalance
■ MoneyDemand
● AnincreaseinYcausesanincreaseinmoneydemand,otherthingsequal
○ IfYrises
■ Householdswanttobuymoregoodsandservices,so
theyneedmoremoney
■ Togetthismoney,theyattempttosellsomeoftheir
bonds
○ TheDownwardSlopeoftheAggregateDemandCurve
■ Interestrateeffect
● (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
■ Thesameworksforadeclineinthepricelevel:
● Alowerpricelevelreducesmoneydemand
● whichleadstoalowerinterestrate
● increasesthequantityofgoodsandservicesdemanded
■ Resultsinanegativerelationshipsbetweenthepricelevelandthequantityof
goodsandservicesdemanded
○ ChangesintheMoneySupply
■ WhentheFedincreasesthemoneysupply,itlowerstheinterestrateandincreases
thequantityofgoodsandservicesdemandedforanypricelevel
● ShiftsADcurvestotheright
■ WhentheFedcontractsthemoneysupply,itraisestheinterestrateandreduces
thequantityofgoodsandservicesdemandedforanygivenpricelevel
● ShiftsADcurvetotheleft
○ TheRoleofInterestRateTargetsinFedPolicy
■ ChangesinmonetarypolicyaimedatexpandingAD
● Increasingthemoneysupply
● Loweringtheinterestrate
■ ChangesinmonetarypolicyaimedatcontractingAD
● Decreasingthemoneysupply
● Raisingtheinterestrate
FiscalPolicyandAggregateDemand
Fiscalpolicythesettingofthelevelofgovernmentspendingandtaxationbygovernment
policymakers
○ ChangesinGovernmentPurchases
■ Whenthegovernmentaltersitsownpurchasesofgoodsandservices,itshiftsthe
aggregatedemandcurvedirectly
Expansionaryfiscalpolicy
○ AnincreaseinGand/ordecreaseinT
○ ShiftsADright
Contractionaryfiscalpolicy
○ AdecreaseinGand/orincreasesinT
○ ShiftsADleft
■ Ex.TheU.SDefenseplacesa$20billionorderfornewplanes.
● Thisorderraisesthedemandfortheoutputproducedbytheplane
company
● Inducesthecompanytohiremoreworkersandincreaseproduction
● Theincreasesinthedemandforplanesmeansanincreaseinthetotal
quantityofgoodsandservicesdemandedateachpricelevel
● ADcurveshiftstotheright
○ (1)TheMultiplierEffecttheadditionalshiftsinaggregatedemandthatresultwhen
expansionaryfiscalpolicyincreasesincomeandtherebyincreasesconsumerspending
■ Eachdollarspentbythegovernmentcanraisetheaggregatedemandforgoods
andservicesbymorethanadollar
○ AFormulafortheSpendingMultiplier
■ Multiplier=1/(1x)
● x=MPC
■ MarginalPropensitytoConsume(MPC)
● Thefractionofextraincomethatahouseholdconsumesratherthansaves
○ MPC=ChangeinConsumption/ChangeinDisposable
income
=C/Y
D
■ MarginalpropensitytoSave
● Thefractionofeachadditional(marginal)dollarofdisposableincomenot
spendonconsumption
● MPC=1MPC
● MPC=ChangeinSaving/ChangeinDisposableIncome
 =S/Y
D
○ (2)TheCrowdingOutEffecttheoffsetinaggregatedemandthatresultswhen
expansionaryfiscalpolicyraisestheinterestrateandtherebyreducesinvestmentspending
■ Whileanincreaseingovernmentpurchasesstimulatestheaggregatedemandfor
goodsandservices,italsocausestheinterestratetorise
● Reducesinvestmentspending
● Putsdownwardpressureonaggregatedemand
■ Whenthegovernmentincreasesitspurchasesofgoodsandservices
● Increaseinincomeraisesthedemandformoney
● Causesequilibriuminterestratetorise
● Quantityofgoodsandservicesdemandedfalls
■ Offsetstheimpactoffiscalexpansiononaggregatedemand
○ ChangesinTaxes
■ Whenthegovernmentcutspersonalincometaxes,itincreaseshouseholds’
takehomepay
● Increaseinconsumerspending
● Taxcutshiftstheaggregatedemandcurvetotheright
■ Taxincreasewoulddepressconsumerspending
● ShiftsADtotheleft
■ Multipliereffectandcrowdingoutaffectsthesizeoftheshiftinaggregatedemand
■ Additionally,households’perceptionsaboutwhetherthetaxchangeispermanent
ortemporarywillaffectthesizeoftheshiftinAD
● Ex.Supposethatthegovernmentannouncesataxcutof$1,000.While
decidinghowmuchofthistospend,householdswillaskthemselveshow
longthisextraincomewilllast
○ Iftheyexpectthetaxcuttobepermanent,theywillincreasetheir
spendingbyalargeamount
UsingPolicytoStabilizetheEconomy
○ TheCaseforActiveStabilizationPolicy
■ Changesinattitudesbyhouseholdsandfirmsshiftaggregatedemand
■ Ifthegovernmentdoesnotrespond,theresultisundesirableandunnecessary
fluctuationsinoutputandemployment
○ TheCaseagainstActiveStabilizationPolicy
■ Monetaryandfiscalpolicyworkwithsuchlonglagsthatattemptsatstabilizingthe
economyoftenendupbeingdestabilizing
AutomaticStabilizerschangesinfiscalpolicythatstimulateaggregatedemandwhenthe
economygoesintoarecessionwithoutpolicymakershavingtotakeanydeliberateaction