Economic Policy. Sherif Khalifa. Sherif Khalifa () Economic Policy 1 / 23

Transcription

1 Sherif Khalifa Sherif Khalifa () Economic Policy 1 / 23

2 Monetary Policy Definition Monetary policy is the setting of the money supply by policy makers in the central bank. Money supply is determined by the central bank according to monetary policy, so the supply curve is vertical. An increase in the interest rate increases the cost of holding money and decreases the quantity of money demanded. The equilibrium interest rate is the one at which the quantity of money demanded exactly balances the quantity of money supplied. Sherif Khalifa () Economic Policy 2 / 23

3 Monetary Policy Interest Rate MS r 1 MD Quantity of Money Sherif Khalifa () Economic Policy 3 / 23

4 Monetary Policy A higher price level increases the quantity of money demanded. Higher money demand leads to a higher interest rate. At a higher interest rate, the cost of borrowing and the return to saving are higher. Higher interest rate decreases the quantity of goods and services demanded. Sherif Khalifa () Economic Policy 4 / 23

5 Monetary Policy r MS P r 2 P 2 r 1 P 1 MD 2 MD 1 AD M Y 2 Y 1 Y Sherif Khalifa () Economic Policy 5 / 23

6 Monetary Policy When the Fed increases money supply, it decreases the interest rate. This increases the quantity of goods and services demanded for any given price level. This shifts the aggregate demand curve to the right. When the Fed decreases money supply, it increases the interest rate. This decreases the quantity of goods and services demanded for any given price level. This shifts the aggregate demand curve to the left. Sherif Khalifa () Economic Policy 6 / 23

7 Monetary Policy r MS P r 1 P 1 AD 2 r 2 MD 1 M Y 1 Y 2 AD 1 Y Sherif Khalifa () Economic Policy 7 / 23

8 Monetary Policy Discussions of monetary policy often treat the interest rate, rather than the money supply as the central bank s instrument. The Fed has conducted policy by setting a target for the Federal funds rate, the interest rate that banks charge one another for short term loans. When the Fed sets a target for the interest rate, it commits itself to adjusting the money supply to make the equilibrium in the money market hit that target. Changes in monetary policy aimed at expanding aggregate demand can be described either as increasing the money supply or as decreasing the interest rate. Changes in monetary policy aimed at contracting aggregate demand can be described either as decreasing the money supply or as increasing the interest rate. Sherif Khalifa () Economic Policy 8 / 23

9 Fiscal Policy Definition Fiscal policy is the setting of the level of government spending and taxation by government policymakers. Expansionary fiscal policy means an increase in governemnt spending and/or decrease in taxes, shifts aggregate demand right. Contractionary fiscal policy: a decrease in government spending and/or increase in taxes, shifts aggregate demand left. When the government alters its own purchases of goods and services, it shifts the aggregate demand curve directly. When the government alters its tax systems and laws, it shifts the aggregate demand curve indirectly. Sherif Khalifa () Economic Policy 9 / 23

10 Fiscal Policy Definition The multiplier effect is the additional shifts in aggregate demand when expansionary fiscal policy increases income and thereby increases consumer spending. Definition The marginal propensity to consume is the fraction of extra income that a household consumes rather than saves. Sherif Khalifa () Economic Policy 10 / 23

11 Fiscal Policy Y = C + I + G Y = C + G Y = (MPC ) Y + G ( ) 1 Y = G 1 MPC Multiplier = Y G = 1 1 MPC Sherif Khalifa () Economic Policy 11 / 23

12 Fiscal Policy r MS P r 2 r 1 AD 2 MD 2 AD 3 M MD 1 AD 1 Y Sherif Khalifa () Economic Policy 12 / 23

13 The increase in demand due to the increase in government spending from a firm increases the incomes of the workers and owners of this firm. As incomes increase, households plan to buy more goods and services and choose to hold more of their wealth in liquid form. The increase in income caused by fiscal expansion increases the demand for money, which increases the interest rate. The increase in the interest rate decreases the quantity of goods and services demanded for investment. This crowds out investment which partially offsets the initial impact of the increase in government spending. Sherif Khalifa () Economic Policy 13 / 23 Economic Policy Fiscal Policy Definition Crowding out is the offset in aggregate demand that occurs when expansionary fiscal policy increases the interest rate and decreases investment spending.

14 Phillips Curve Definition The Phillips curve is a curve that shows the short run trade off between inflation and unemployment. Unemployment rate = Natural rate of unemployment a (Actual inflation Expected inflation) Sherif Khalifa () Economic Policy 14 / 23

15 Phillips Curve Inflation Rate Phillips Curve Unemployment Rate Sherif Khalifa () Economic Policy 15 / 23

16 Phillips Curve P SRAS Π High AD Low AD Y 4 7 U PC Sherif Khalifa () Economic Policy 16 / 23

17 Phillips Curve Unemployment does not depend on money growth and inflation in the long run. Monetary growth does not influence the factors that determine the economy s unemployment rate such as power of unions, effi ciency wages, and job search. Regardless of the monetary policy pursued by the central bank, output and unemployment are at their natural rates in the long run. There is no long run trade off between inflation and unemployment. Sherif Khalifa () Economic Policy 17 / 23

18 Phillips Curve Inflation Rate LRPC High Inflation Low Inflation Natural Rate of Unemployment Unemployment Rate Sherif Khalifa () Economic Policy 18 / 23

19 Phillips Curve Inflation Rate LRPC SRPC 2 /High π e U N SRPC 1 /Low π e Unemployment Rate Sherif Khalifa () Economic Policy 19 / 23

20 Phillips Curve P LRAS 1 SRAS Π LRPC 1 1 A B B A C C AD 2 AD 3 AD 1 SRPC 1 Y N Y U N U Sherif Khalifa () Economic Policy 20 / 23

21 Phillips Curve P LRAS 1 SRAS 2 SRAS 1 Π LRPC 1 D SRAS 3 D A A E E SRPC 2 AD 1 SRPC 3 SRPC 1 Y N Y U N U Sherif Khalifa () Economic Policy 21 / 23

22 Phillips Curve P LRAS 1 SRAS Π LRPC 1 1 SRAS 2 B A A B C C SRPC 1 AD 2 AD 1 SRPC 2 YN Y U N U Sherif Khalifa () Economic Policy 22 / 23

23 Phillips Curve Definition The sacrifice ratio is the number of percentage points of annual output lost in the process of decreasing inflation by 1 percentage point. Sacrifice ratio = % Y % π Sherif Khalifa () Economic Policy 23 / 23