Macroeconomics Chapter 34 - Influence Of Monetary And Fiscal Policy On Aggregate Demand

Front 1

AD curve slopes downward for three reasons:

Back 1

- The wealth effect
- The interest-rate effect (most important for US economy)
- The exchange-rate effect

Front 2

The Theory of Liquidity Preference (Basics)

Back 2

Keynes' theory that the interest rate (r) adjusts to bring money supply and money demand into balance.

- money supply: assume fixed by the central bank, does not depend on interest rate
- money demand reflects how much wealth people want to hold in liquid form
- suppose household wealth includes only two assets:
--Money: liquid, but no interest
--Bonds: interest, but not as liquid
-A household's 'money demand' reflects its preference for liquidity
-The variables that influence money demand: Y, r, and p

Front 3

Money Demand

Back 3

An increase in Y causes an increase in money demand, other things equal

(If Y rises: households want more g&s, so they need more money / to get money, they attempt to sell some of their bonds)

Front 4

How r is determined

Back 4

MS curve is vertical: changes in r do not affect MS, which is fixed by central bank.

MD curve is downward sloping: a fall in r increases money demand

Front 5

How interest-rate effect works

Back 5

1. A higher price level (P) raises money demand (MD)
2. Higher MD leads to a higher interest rate (r)
3. A higher r reduces the quantity of goods and services (Y) demanded

Front 6

The effects of reducing the money supply

Back 6

- The Fed can raise r by reducing the money supply.
- An increase in r reduces the quantity of g&s demanded.

Front 7

Liquidity traps

Back 7

Monetary policy stimulates aggregate demand by reducing the interest rate. Liquidity trap occurs when interest rate is zero.

Front 8

Fiscal Policy and Aggregate Demand

Back 8

Fiscal Policy: the setting of the level of gov't spending and taxation by gov't policymakers

-Expansionary fiscal policy: an increase in G and/or decrease in T (shifts AD right)
-Contractionary fiscal policy: a decrease in G and/or increase in T (shifts AD left)

Front 9

Fiscal policy has two effects on AD

Back 9

1. The Multiplier Effect: The shift in AD that results when fiscal policy increases income and thereby increases consumer spending

2. The Crowding-Out Effect: A fiscal expansion raises r, which reduces investment, which reduces the net increase in AD. The size of the AD shift may be smaller than the initial fiscal expansion.

Front 10

Marginal propensity to consumer (MPC)

Back 10

The fraction of extra income that households consume rather than save (bigger MPC means bigger change in Y)

Change Y = [1/(1-MPC)] x Change in G

Front 11

How crowding-out effect works

Back 11

- An increase in G initially shifts AD right
- But higher Y increases MD and r, which reduces AD

Front 12

Fiscal Policy and Aggregate Supply

Back 12

Fiscal policy might also affect agg supply: a cut in the tax rate gives workers incentive to work more, so it might increase the quantity of g&s supplied and shift AS to the right. However, this effect is probably more relevant in the long run.

Front 13

The case FOR active stabilization policy

Back 13

-Keynes: 'animal spirits' cause waves of pessimism and optimism among households and firms, leading to shifts in aggregate demand and fluctuations in output and employment.

-Other factors cause fluctuations (booms/recessions abroad, stock market, etc.)...if policymakers do nothing, these fluctuations are destabilizing.

Front 14

The case AGAINST active stabilization policy

Back 14

-Monetary policy affects economy with a long lag (I takes time to respond to r, most economist believe it takes at least 6 months to affect output and employment)

-Fiscal policy also works with a long lag (changes in G and T require long process of legislation)

-By the time the policies affect agg demand, the economy's condition may have changed

-Theses critics contend that policy makers should focus on long-run, like economic growth and low inflation

Front 15

Automatic stabilizers

Back 15

Changes in fiscal policy that stimulate agg demand when economy goes into recession, without policymakers having to take any deliberate action (tax system, gov't spending)