I. The Money Market. A. Money Demand (M d ) Handout 9

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1 University of California-Davis Economics 1B-Intro to Macro Handout 9 TA: Jason Lee jawlee@ucdavis.edu In the last chapter we developed the aggregate demand/aggregate supply model and used it to help explain what caused short-run economic fluctuations. In this chapter we will look at what tools policymakers have to address these short-run fluctuations. As a preview we will see that policymakers have two key tools: (1) Monetary Policy: Monetary policy is the control of the money supply in the economy. The central bank (the Federal Reserve in the United States) has control over the money supply. (2) Fiscal Policy: Fiscal policy is governmental spending and taxation policy. In the United States fiscal policy is determined by the President and Congress. Monetary and fiscal policy are key towards stabilizing the economy because they both cause the aggregate demand curve to shift. In particular, if we have expansionary monetary policy (increase in the money supply) or expansionary fiscal policy (increase in government spending or decrease in taxes) then the aggregate demand curve will shift to the right. On the other hand if we have contractionary monetary policy (decrease in the money supply) or contractionary fiscal policy (decrease in government spending or decrease in taxes) then the aggregate demand curve will shift to the left. I. The Money Market The money market looks at the supply and demand for money. The point at which the supply of money equals the demand for money is where interest rates are determined. Let s take a brief look at the supply and demand for money components. A. Money Demand (M d ) The demand for money is intuitive since you make decisions everyday about how much currency you wish to hold. One of the reasons we like to hold money is because we use it to conduct transactions of goods and services. This is known as the transaction demand for money. However, the problem with holding lots of currency is that you don t earn any interest in holding cash. That can be a problem when interest rates are high. If you could earn 10% interest at a bank, then keeping $1000 in currency will cost you $100 over the year. Thus the interest rate is the opportunity cost of holding money. As interest rates increase, the opportunity cost of holding money increases and thus a rational person will want to hold less money in cash. Conversely, if interest rates decrease then the opportunity cost of holding money is lower and people might want to hold more money. This idea of interest rate acting as the opportunity cost of holding money is captured by the money demand curve. The money demand curve shows the negative relationship associated between the interest rate and the amount of money held.

2 Figure 1 When interest rates change we move along the demand curve for money. While interest rates are a primary determinant of the demand for money, there are other factors. Each of these other factors will cause the demand curve to money to shift. Change in the price level: If prices of all goods were to suddenly double overnight, people will need twice the currency as before to purchase the same amount of goods. This will increase the demand for money. Figure 2 illustrates this change. Figure 2 Suppose we start at an initial point where the economy is at interest rate r o. At that interest rate the amount of money demanded is at M o. Now if the price level were to double that s going to increase the demand for money. At the same interest rate of r o, people are going to demand more money (say M 1 ). We re no longer on our original money demand curve, the curve must shift out to the right. Thus an increase in the price level will increase the demand for money. You can easily see that a decrease in the price level will have the opposite effect. Change in the income level (Y): If suddenly you were to achieve the wealth of Oprah overnight, that will drastically affect your consumption patterns. As income goes up, people tend to purchase more goods and thus will need more currency in order to conduct these transactions. Thus as the income level increases money demand will increase and shift to the right. (Figure 2 illustrates this). B. Money Supply (M s ) The money supply in the economy is determined by the Federal Reserve independent of the interest rate. We assume that the Fed chooses some given amount of money to supply to the economy. Thus the money supply curve is vertical.

3 Shifting the Money Supply Curve Suppose that the Federal Reserve wishes to increase or decrease the amount of money it chooses to supply to the economy. How would it go about achieving this? Open Market Operations: The principal tool at the disposal of the Federal Reserve is something called open market operations. Open market operations is nothing more than the buying and selling of U.S. government securities (bonds). There are two open market operations 1. Open market purchases-when the Federal Reserve wishes to I CREASE THE MO EY SUPPLY they will conduct open market purchases. The way it works is that the Fed will buy bonds and other government securities from individual investors (and sometimes banks directly). What will then happen is that these investors will deposit the money that was given to them by the Fed into their checking accounts. As we saw in Chapter 11, an increase in deposits will lead to an increase in total deposits (and hence money) through the money multiplier. Review Ch. 11 if you re unsure how this process works. 2. Open market sales-when the Federal Reserve wishes to DECREASE THE MO EY SUPPLY they will conduct open market sales. In this process, the Fed will now sell bonds and government securities to individual investors. These investors will write checks to purchase these bonds. Thus the deposits in the bank will decrease and through the money multiplier system will decrease throughout the banking system. Changing the Reserve Requirement Ratio: A tool that is rarely used to change the money supply is to change the reserve requirement ratio. Think about how changing the ratio will affect money supply. Suppose that the Fed decides to increase the reserve requirement ratio. The result would be that the banks will have to hold more of the deposits as reserves and thus will have less to lend out in loans. Thus increasing the reserve requirement ratio will decrease the supply of money. Conversely by decreasing the reserve requirement ratio will increase the supply of money. Changing the Discount Rate: When banks want to borrow from the Federal Reserve the Fed charges them a special interest rate called the discount rate. The discount rate is the interest that the banks have to pay to the Fed. Decreasing the discount rate will increase the supply of money. If the Fed decreases the interest rate it charges banks, banks will be more willing to borrow the money from the Fed. They can then use the money to issue out loans and thus more money is created through the system. An increase in the discount rate will have the opposite effect. C. Money Market Equilibrium Not surprisingly money market equilibrium is going to be where the demand for money curve intersects the supply for money curve.

4 Figure 3 Note that we can find equilibrium interest rate, where money supply and money demand intersects. D. The Money Market and Aggregate Demand Back in Chapter 15 we saw that a change in money supply would cause the aggregate demand curve to shift. At the time we gave a very simple answer on why that would be the case. Here we will provide a more complete picture on why an increase (decrease) in money supply will cause the aggregate demand curve to shift to the right (left). Figure 6 Shows the complete process Step #1: The Federal Reserve engages in an open market purchase which increases the supply of money. The money supply curve shifts to the right and the interest rate falls. Step #2: From Ch.12 we know that when interest rates fall (in this case from r o to r 1 ), investment will increase. Step #3: An increase in investment will shift the aggregate demand curve to the right. At any given price level, the amount of output in the economy will

5 be higher since investment is higher. The reason is that Y = C + I + G + X thus if I increases Y must be higher at the same price level. As an exercise to see if you understand the process you should work it in reverse and see what happens when the Fed engages in an open market sale. E. Interest Rate Targets and Fed Policy In practice, the way the Federal Reserve conducts its monetary policy is through targeting the federal funds rate (the interest rate that banks charge one another for short-term loans). But as we shall see changing the targeted federal funds rate is equivalent to changing the money supply. In fact monetary policy can be described either in terms of the money supply or in terms of the interest rate. The reason we can make that claim, is that once the Fed sets its target interest rate, it either buys or sells enough bonds to make sure that the equilibrium interest rate in the money market is equal to the target interest rate. Thus when you hear in the news that the Fed has lowered interest rate to 1% from 2% keep in mind what it must be doing behind the scenes. In order to lower the interest rate, it must purchase bonds in the open market, which injects reserves into the banking system and would increase the money supply. In the graph of the money market the money supply curve will shift to the right and lower the interest rate to the target interest rate. II. Fiscal Policy and Aggregate Demand We now turn to the other tool that policymakers have and that is fiscal policy (increasing government spending or changing taxes). As we saw in the last chapter, changes in government spending or taxes will clearly have an effect on aggregate demand. If government spending increases (or if taxes decreases) this will shift the aggregate demand curve to the right, while if government spending decreases (or if taxes increases) this will shift the aggregate demand curve to the left. However, the question of interest here is by how much would the aggregate demand curve shift given a change in either government spending or taxes. A. Government Purchases Multiplier An important point is that a $1 increase in government spending will result in a greater than $1 increase in real GDP. This fact is known as the multiplier effect. The reason is relatively straightforward. If the government increases spending by $100 it will have an immediate impact of increasing Y by $100. However, since consumption depends on Y, an increase of Y by $100 will increase consumption which in turns increase Y even more. This further increase in Y will increase consumption again and so forth. It turns out the government purchases multiplier is calculated as Y/ G (how much real GDP changes from a change in government spending) 1 which can be found to be. where mpc is equal to the marginal propensity to consumer. 1 mpc Key Point: An increase in government spending by $X will increase output by more than $X due to the positive feedback outlined above. This is known as the government multiplier effect.

6 B. Deriving the Government Purchases Multiplier For those interested here is a straightforward proof for the government purchases multiplier. We first have to introduce the consumption function. The consumption function is an equation that tells us how much households are willing to consumer for a given level of disposable income. Formally it can be written as: C = C 0 + mpc(y-t) Where C 0 = intercept term which represents additional factors that could affect consumption mpc = the marginal propensity to consume. This is the slope of the consumption function. The marginal propensity to consume is the fraction of disposable income that households consumer. For example if mpc = 0.75 this implies that out of each dollar the households receives in disposable income, the household will spend $0.75 in consumption. (Y-T) = disposable income. We know that an increase in G will have an immediate impact on Y. Suppose that government spending increases by $1000 ( G = $1000). is used as a shorthand notation for change. This increase in $1000 will cause Y to increase by $1000 since Y = C + I + G + NX. Y = G (the change in real GDP is equal to the change in government spending) However it doesn t end there. Looking at the consumption function, we see that any increase in output will cause consumption to go up. How much will consumption increase? To simplify matters let s put some hypothetical numbers. Let s have C 0 = $1000 and T = $500 let Y = 1000 (initially) and mpc = 0.80 Initial consumption (before the increase in government spending) was C = $ ( ) = $1400 What happens after government spending increases by $1000? We know that output level increases by $1000 initially. So Y = Everything else is assumed to be held constant. How much has consumption changed? C = $ ( ) = $2200 C = $800 Because of the increase in government spending consumption has increased by $800 from before. This is equivalent to mpc( G) = 0.80($1000). Thus since C increased by $800, Y must also increase by $800 since Y = C + I + G + NX. However an increase in Y by $800 will once again affect consumption. Real GDP is now $2800. C = $ ( ) = $2840

7 C = $640 which is equivalent to (mpc) 2 G We could continue on in a similar fashion. Note that initially real GDP increased by G Then real GDP increased by (mpc) G Then real GDP increased by (mpc) 2 G Y = (1 + mpc + mpc 2 + mpc 3 + ) G Using some algebra we get (1/(1-mpc)) G 1/(1-mpc) is known as the government purchases multiplier A similar multiplier effect also exists for a change in taxes. The tax multiplier is calculated as mpc Y/ T or. You should be able to prove this multiplier using the steps outlined above. 1 mpc C. Fiscal Policies and Stabilization There are times when the economy is not at full employment (potential) output. Current output could be below potential output (a recession) or current output might be above potential output (an expansion). Fiscal policies are useful in bringing current output back to potential output. As we saw in the last handout one way in which output could be increased is through expansionary fiscal policies. Expansionary fiscal policies are either an increase in government spending or a decrease in taxes. The result of these policies is a shift of the Aggregate Demand curve to the right. Thus whenever current output is below potential output, policymakers might want to use expansionary fiscal policies. Conversely, a way in which output could be decreased is through contractionary fiscal policies. Contractionary fiscal policies are either a decrease in government spending or an increase in taxes. The result of these policies is a shift of the Aggregate Demand curve to the left. In cases when the economy has current output above potential output, contractionary fiscal policies would be effective in bringing about stabilization. Unfortunately for policymakers, the use of fiscal policies to move the economy back to potential output is not easy as it might appear. The central problem are that fiscal policies are not instantaneous and it takes time before these policies can take effect. At worse, these the time lag can be so long, that by the time the fiscal policies start working, the economic fluctuation no longer exists. There are two reasons why it takes time for fiscal policies to be effective: (1) Inside Lags: The time it takes to identify an economic fluctuation and come up with a policy solution.

8 The first problem is that the fact that policymakers have to first identify an economic fluctuation. With so much economic data available, just being able to identify a recession or boom may be difficult. Even when policymakers can finally identify an economic fluctuation, finding a solution is problematic. It takes time to pass tax or spending bills through Congress. Inside lags are the main reason why fiscal policies take time to be effective. (2) Outside Lags: Time it takes for the fiscal policy to work after it has been enacted. Typically outside lags do not last very long.