The Influence of Monetary and Fiscal Policy on AD. Ch. 21, Mankiw

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2 The Influence of Monetary and Fiscal Policy on AD Ch. 21, Mankiw

3 What influences AD?

4 How can gov. policy/tools affect AD? -Monetary policy (MS) -Fiscal Policy (G and taxation) ~Inside and Outside lag? Why the slope? review -Interest rate effect P M people hold onto I%.: Q of G/S D -Wealth effect P Real Wealth C.: Q of G/S D -Exchange effect P I% Currency NE.: Q of G/S Which is more important? W (3 rd ), E (2 nd ), then I (1 st )

5 To better understand AD, let s look at

6 Liquidity Preference -I% to balance out MS and MD

7 How do we arrive at this idea of LP?

8 LP exists because -Money Supply -Tools of the fed all lead to a control of MS -Money Demanded -Money is the most liquid asset Used for nearly all G/S -An increase in I% raises the cost of holding money

9 So how does is I% determined? You said it was changed to balance out S and D of LF and then you said it was to balance out the S and D for money?

10 Well, it s both Variables central to output of G/S 1. Output: determined by capital, labor, and tech. 2. I% adjusts to balance the S/D for loanable funds 3. Given Y and I%, the PL adjusts to balance the S/D for M.: Ms lead to proportionate in PL 1. Sticky prices, PL tends to be unresponsive 2. For any I%, the PL adjusts 3. I% that balances MMkt. changes the Q of G/S D.: in PL Long Run (Classic view) Short Run

11 Well, it s both Variables central to output of G/S 1. Output: determined by capital, labor, and tech. 2. I% adjusts to balance the S/D for loanable funds 3. Given Y and I%, the PL adjusts to balance the S/D for M.: Ms lead to proportionate in PL 1. Sticky prices, PL tends to be unresponsive 2. For any I%, the PL adjusts 3. I% that balances MMkt. changes the Q of G/S D.: in PL Long Run Short Run Ah-ha, I checked the Google! Same thing, different path of arrival. When looking at long run we focus on Ioanable funds (our MPS and I), while short run focuses on monetary policy and liquidity.

12 A. Suppose I% rises, but Y and P are unchanged. What happens to money demand? B. Suppose P rises, but Y and I% are unchanged. What happens to money demand?

13 A. Suppose I% rises, but Y and P are unchanged. What happens to money demand? I% is the opportunity cost of holding money. An increase in I% reduces money demand: Households attempt to buy bonds to take advantage of the higher interest rate. Hence, an increase in I% causes a decrease in money demand, other things equal.

14 B. Suppose P rises, but Y and I% are unchanged. What happens to money demand? If Y is unchanged, people will want to buy the same amount of G&S. Since P is higher, they will need more money to do so. Hence, an increase in P causes an increase in money demand, other things equal.

15 (a) The Money Market (b) The Aggregate-Demand Curve Interest Rate Money supply increases the demand for money... Price Level r 2 P 2 Money demand at price level P 2, MD which increases the equilibrium interest rate... r 0 Quantity fixed by the Fed Money demand at price level P, MD Quantity of Money 1. An increase in the price level... P 0 Aggregate demand Y 2 Y Quantity of Output which in turn reduces the quantity of goods and services demanded.

16 In MS -Monetary policy important to shifts in AD -Scenario: Fed MS through OMO MS I% (to balance out) That is, the I% must to induce people to hold additional M the Fed s created.

17 A Monetary Injection (a) The Money Market (b) The Aggregate-Demand Curve Interest Rate Money supply, MS MS 2 Price Level r 1. When the Fed increases the money supply... P the equilibrium interest rate falls... r 2 Money demand at price level P AD 2 Aggregate demand, A D 0 Quantity of Money 0 Y Y Quantity of Output which increases the quantity of goods and services demanded at a given price level.

18 Wrap up -When the Fed MS it I% and G/S D.: AD

19 What of I%? -Recent years have shown the Fed playing with FFR Fed sets FFR as target as opposed to the MS -So, monetary policy can be described as MS or I%

20 Headline: Fed lowers interest rate from 6-5% Translation: Fed has authorized traders to purchase bonds in order to Eq I% So Monetary Policy aimed at AD as MS or I% can be described

21 So why then, does the Fed care so much about the stock market?

22 - Stocks can influence AD - Fed may I%, which would make bonds relatively more attractive than stocks and drop AD (stocks look less attractive) - Ergo: When Ben hikes rates, stocks prices fall

23 How can these guys alter AD?

24 Fiscal Policy s influence on AD s in G When G then AD How much? Multiplier or Crowding out

25 For each of the events below, - determine the short-run effects on output - determine how the Fed should adjust the money supply and interest rates to stabilize output A. Congress tries to balance the budget by cutting govt spending. B. A stock market boom increases household wealth. C. War breaks out in the Middle East, causing oil prices to soar.

26 A. Congress tries to balance the budget by cutting govt spending. This event would reduce AD and output. To offset this event, the Fed should increase MS and reduce I% to increase AD.

27 B. A stock market boom increases household wealth. This event would increase AD, raising output above its natural rate. To offset this event, the Fed should reduce MS and increase I% to reduce AD.

28 C. War breaks out in the Middle East, causing oil prices to soar. This event would reduce SRAS, causing output to fall. To offset this event, the Fed should increase MS and reduce I% to increase AD.

29 Price Level The Multiplier Effect but the multiplier effect can amplify the shift in aggregate demand. $20 billion AD 3 AD 2 Aggregate demand, AD An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion... Quantity of Output

30 Crowding Out -An increase in government purchases causes the interest rate to rise. -A higher interest rate reduces investment spending.

31 The Crowding-Out Effect (a) The Money Market (b) The Shift in Aggregate Demand Interest Rate Money supply the increase in spending increases money demand... Price Level $20 billion which in turn partly offsets the initial increase in aggregate demand. r which increases the equilibrium interest rate... r M D 2 Money demand, MD AD 3 Aggregate demand, AD 1 AD 2 0 Quantity fixed by the Fed Quantity of Money 0 1. When an increase in government purchases increases aggregate demand... Quantity of Output

32 in Taxes -When Taxes AD -Also influenced by multiplier and crowding out -And our perception of the permanency of the cut

33 Using policy to stabilize the economy - Employment Act of 1946, which states that: it is the continuing policy and responsibility of the federal government to promote full employment and production. ~Implications: 1. Gov. should avoid causing econ fluctuations 2. Gov. should stabilize AD The Federal Reserve s job is to take away the punch bowl just as the party gets going. William McChesney Martin

34 Fin!