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LESSON 10 Economic Fluctuations: Effects of Fiscal and Monetary Policy Assigned Reading 1. Mankiw, N.G., et al. 2014. Principles of Macroeconomics (6 th Canadian Edition). Toronto: Nelson Education Ltd. Chapter 15: The Influence of Monetary and Fiscal Policy on Aggregate Demand Recommended Reading 1. Mankiw, N.G., et al. 2014. Study Guide for use with the Principles of Macroeconomics, (6 th Canadian Edition). Toronto: Nelson Education Ltd. Chapter 15: The Influence of Monetary and Fiscal Policy on Aggregate Demand Learning Objectives After studying this lesson, students should be able to: 1. explain the liquidity preference theory and its role in determining the money demand curve; 2. describe how equilibrium occurs in the money market; 3. analyze how monetary policy affects interest rates, aggregate demand, and output in a closed economy; 4. analyze how monetary policy affects interest rates, aggregate demand, and output in an open economy, with either a flexible or fixed exchange rate policy; 5. describe the role of government expenditures and the multiplier effect on aggregate demand; 6. provide examples of applications of the multiplier effect; 7. explain how government expenditure can crowd-out private investment; 8. analyze how fiscal policy affects interest rates, exchange rates, aggregate demand, and output in an open economy with flexible exchange rates; 9. analyze how fiscal policy affects interest rates, exchange rates, aggregate demand, and output when the central bank maintains fixed exchange rates; 10. discuss the debate over whether policymakers should try to stabilize the economy; and 11. define automatic stabilizers and explain how they affect aggregate demand. 10.1
Lesson 10 Instructor's Comments This lesson includes considerable detail and complexity as it covers the ways that monetary and fiscal policies pursued by the Bank of Canada and the government affect the economy in the short run. The key to this lesson is the effect foreign trade and capital flows have on these policies. The effects of monetary and fiscal policy depend on whether an economy is closed or open, and for the latter whether there is policy to let exchange rates float (flexible exchange rates) or keep them fixed. In the previous lesson, we found that when aggregate demand or short-run aggregate supply shifts, it causes fluctuations in output. As a result, policymakers sometimes try to offset these shifts by shifting aggregate demand with monetary and fiscal policy. This lesson introduces government fiscal policy and explains how tax and spending policies can affect aggregate demand in the short run. This lesson addresses the theory behind monetary and fiscal policy and some of the shortcomings of stabilization policy. The lesson concludes with a comparison of the short-run and long-run effects of fiscal and monetary policy on prices and output. In the past, one of the biggest debates in economics was over the relative importance of monetary and fiscal policy in influencing aggregate demand. In its extreme form, the Keynesian view argued that fiscal policy is the key to controlling aggregate demand. Monetarists responded that it was monetary policy that mattered, through its effect on investment. The reading for this lesson examines the empirical evidence and reports that both affect aggregate demand. It is possible to use both together, but since fiscal policy is determined by the Federal Government and monetary policy by the Bank of Canada, the objectives and outcomes may, on occasion, be conflicting. What this lesson emphasizes is how being an open economy affects these policies, and central to this is whether the Bank of Canada is pursuing a strategy of floating (flexible) exchange rates or not. The text demonstrates that with flexible exchange rates, fiscal policy has no affect on the equilibrium level of output. However, if the national policy is to keep exchange rates stable, then any change in government expenditures or tax rates must be followed by intervention by the Bank of Canada in foreign currency markets by either buying or selling dollars. In this case, fiscal policy does affect the quantity of output. In a closed economy, real estate is primarily affected by monetary policy. When the money supply increases, nominal interest rates fall and the supply of loanable funds is increased. Since loans for housing construction and mortgages compete with other forms of investment for the available funds, this form of "loose" monetary policy will lower the interest rate on mortgages. Consequently, the demand for mortgages will rise as home ownership becomes more affordable, bringing new households into the market and increasing residential construction. Some of these purchasers may have been delaying the decision to purchase housing, waiting for more favourable interest rates. In this case, a reduction in interest rates may lead to a very rapid increase in the demand for housing units and a subsequent increase in prices. As we learn in this lesson, in an open economy, the interest rate cannot deviate from the world rate. In this case, the relationship between monetary policy and real estate more closely resembles the effects of fiscal policy on real estate. Typically, fiscal policy affects real estate indirectly. While it is true that real estate can be the direct target of government spending or tax policies, through spending on social housing or policies to increase housing affordability through favourable tax treatment or programs for first time buyers, it is more often the case that real estate benefits from the increases in aggregate output triggered by fiscal policy, and by monetary policy in an open economy. When output is higher, households are richer and expenditures on real estate, as with all other goods, increase. In particular, the rise in incomes will mean that there are households who can now afford home ownership who could not previously. 10.2
Economic Fluctuations: Effects of Fiscal and Monetary Policy Review and Discussion Questions 1. Suppose that the federal government reduces its expenditures. What happens to the aggregate demand curve? 2. Suppose that consumers become pessimistic about the future health of the economy, and so cut back on their consumption spending. What will happen to aggregate demand and to output? What would the Bank of Canada have to do if it wanted to keep output stable? 3. What effect would a balanced budget law have on automatic stabilizers? 4. Suppose a shift in aggregate demand puts the economy in recession. Either fiscal policy or monetary policy could be used to eliminate the recession. In terms of the short-run impact on output and prices, is there any difference between the two? 5. Suppose the government spends $2 billion dollars on a public works program that is intended to stimulate aggregate demand in a closed economy. If the crowding-out effect exceeds the multiplier effect, will the aggregate-demand curve shift to the right by more or less than $2 billion? Why? 6. Which is likely to have a greater impact on aggregate demand: a decrease in taxes with a flexible or fixed exchange rate? Why? 7. Suppose the economy is in a recession. Policymakers estimate that aggregate demand is $10 billion short of the amount necessary to generate the long-run natural level of output. That is, if aggregate demand were shifted to the right by $10 billion, the economy would be in long-run equilibrium. (a) (b) (c) (d) (e) If the federal government chooses to use fiscal policy to stabilize the economy, by how much should they increase government spending if the marginal propensity to consume (MPC) is 0.75, the economy is closed, and there is no crowding out? If the federal government chooses to use fiscal policy to stabilize the economy, by how much should they increase government spending if the marginal propensity to consume (MPC) is 0.75, the marginal propensity to import (MPI) in the open economy is 0.25, and there is no crowding out? If there is crowding out of investment spending in a closed economy, will the government need to spend more or less than the amount you found in (a) above? Why? If investment spending by firms in a closed economy is very sensitive to changes in the interest rate, is crowding out more of a problem or less of a problem? Why? If policymakers discover that the lag for fiscal policy in a closed economy is two years, should that make them more likely to employ fiscal policy as a stabilization tool or more likely to allow the economy to adjust on its own? Why? 10.3
Lesson 10 8. You are watching a nightly network news broadcast. The business correspondent reports that the Bank of Canada raised interest rates by a quarter of a percent today to head off future inflation. The report then moves to interviews with prominent politicians. The response of the leader of the official opposition is negative. She says, "The Consumer Price Index has not increased, yet the Bank of Canada is restricting growth in the economy, supposedly to fight inflation. My constituents will want to know why they are going to have to pay more when they get a loan, and I don't have a good answer. I think this is an outrage and I think Parliament should have hearings on the Bank of Canada's policymaking powers." (a) (b) State the Bank of Canada's policy in terms of the money supply. Why might the Bank of Canada raise interest rates before the CPI starts to rise? 9. Explain how each of the following developments would affect the supply of money, the demand for money, and the interest rate. For each case, show what happens in a closed economy and in a small open economy. Illustrate your answers with diagrams. (a) (b) (c) (d) (e) The Bank of Canada's bond traders buy bonds in open-market operations. An increase in credit card availability reduces the cash people hold. Households decide to hold more money to use for holiday shopping. A wave of optimism boosts business investment and expands aggregate demand. An increase in oil prices shifts the short-run aggregate-supply curve to the left. 10. Suppose banks install automatic teller machines on every block and, by making cash readily available, reduce the amount of money people want to hold. (a) (b) Assume the Bank of Canada does not change the money supply. According to the theory of liquidity preference, what happens to the interest rate? What happens to aggregate demand? Assume a closed economy. If the Bank of Canada wants to stabilize aggregate demand, how should it respond? 11. For various reasons, fiscal policy changes automatically when output and employment fluctuate. (a) (b) (c) Explain why tax revenue changes when the economy goes into a recession. Explain why government spending changes when the economy goes into a recession. If the government were to operate under a strict balanced-budget rule, what would it have to do in a recession? Would that make the recession more or less severe? 10.4
Economic Fluctuations: Effects of Fiscal and Monetary Policy ASSIGNMENT 10 CHAPTER 15: The Influence of Monetary and Fiscal Policy on Aggregate Demand Marks: 1 mark per question. 1. According to the theory of liquidity preference there is a(n), at which the quantity of money demanded exactly balances the quantity of money supplied. (1) equilibrium interest rate (2) liquidity interest rate (3) world interest rate (4) domestic interest rate 2. Which of the following is NOT an effect of a monetary injection into a closed economy? (1) A reduction in the equilibrium interest rate. (2) A decrease in the quantity of goods and services demanded at a given price level. (3) An increase in the demand for money. (4) The aggregate-demand curve shifts to the right. 3. In a closed economy, if we assume that there is no crowding-out effect, an increase in government purchases of $10 billion will shift the aggregate demand curve to the by than $10 billion. (1) left, more (2) left, more or less (3) right, more (4) right, more or less THE NEXT THREE (3) QUESTIONS ARE BASED ON THE FOLLOWING DIAGRAM: Assignment 10 continued on the next page 10.5
Lesson 10 4. Which of the following would cause the AD curve to shift from AD1 to AD3? (1) A contraction of the money supply when the exchange rate is flexible (2) An increase in government expenditures when the exchange rate is flexible (3) An expansion of the money supply when the exchange rate is fixed (4) An increase in government expenditures when the exchange rate is fixed 5. If the economy was at point B, a government policy to restore full employment would be: (1) a contraction of the money supply when the exchange rate is flexible. (2) an increase in government expenditures when the exchange rate is flexible. (3) an expansion of the money supply when the exchange rate is fixed. (4) an increase in government expenditures when the exchange rate is fixed. 6. If the economy represented in the diagram was a closed economy and if the economy was at point B, a government policy to restore full equilibrium would be: (1) an increase in the money supply. (2) the reduction in the size of the government deficit. (3) an open-market sale. (4) Both (1) and (3) are correct. 7. Consider the following graph. Assume a closed economy. If the current interest rate is R1: (1) the aggregate quantity of money people are holding is M1. (2) people will be selling bonds, which will drive the interest rate up. (3) people will be buying bonds, which will drive the interest rate up. (4) the quantity of money supplied is M1. 10.6 Assignment 10 continued on the next page
Economic Fluctuations: Effects of Fiscal and Monetary Policy 8. When tax rates are cut, workers get to keep of each dollar they earn, so they have a incentive to work, and as a result, the curve shifts to the. (1) more, greater, aggregate supply, right (2) more, smaller, aggregate demand, right (3) less, smaller, aggregate supply, left (4) less, smaller, aggregate demand, left 9. In a small open economy with perfect capital mobility, if the Bank of Canada chooses to fix the value of the Canadian dollar, an expansionary monetary policy would cause the dollar to and thus require the Bank of Canada to Canadian dollars in the market for foreign currency exchange. (1) depreciate, purchase (2) appreciate, purchase (3) appreciate, sell (4) depreciate, sell 10. In an open economy, if the MPC is 0.8 and the MPI is 0.2, the value of the government expenditure multiplier is: (1) 1 (2) undefined (3) 5 (4) 2.5 11. In a closed economy, if the MPC is 0.75, the multiplier is: (1) 0.25 (2) 4 (3) 5 (4) 0.75 12. Canadian exports and imports make up a large and growing proportion of the Canadian economy, thus the is an increasingly important explanation of why Canada s aggregate-demand curve slopes downward. (1) wealth effect (2) interest-rate effect (3) real exchange-rate effect (4) theory of liquidity preference 13. In a small open economy with perfect capital mobility, a reduction in the size of the government deficit would shift the AD curve: (1) to the left regardless of whether the exchange rate is fixed or flexible. (2) to the right if the exchange rate was flexible. (3) to the left if the exchange rate was flexible. (4) to the left if the exchange rate was fixed. Assignment 10 continued on the next page 10.7
Lesson 10 14. In a closed economy, if the quantity of money demanded is not equal to the quantity of money supplied: (1) the Bank of Canada will adjust the interest rate to the new equilibrium level. (2) there will be a chronic imbalance in the money market. (3) people will try to adjust their portfolios of assets and, as a result, drive the interest rate toward equilibrium. (4) banks will adjust their ratios of reserves to deposits and, as a result, drive the interest rate toward equilibrium. 15. Most of the lag problems associated with the use of monetary and fiscal policy: (1) have been solved in recent years due to better economic forecasting. (2) could be solved if recessions and inflationary cycles could be accurately forecasted. (3) are due to sticky wages. (4) are due to sticky prices. 16. Changes in fiscal policy that stimulate aggregate demand when the economy is going into a recession, without policymakers having to take any deliberate action, is best known as: (1) deficit reduction. (2) active stabilization policy. (3) crowding-out effect on investment. (4) automatic stabilizers. 17. In the long run, fiscal policy influences. In the short run, however, the primary effect of fiscal policy is on. (1) saving, investment, and growth; aggregate demand (2) aggregate demand; aggregate supply (3) aggregate supply; saving, investment, and growth (4) saving, investment, and growth; aggregate supply 18. If the government of Canada increases its purchases by $10 billion, the aggregate-demand for goods and services will: (1) rise by more than $10 billion. (2) rise by less than $10 billion. (3) rise by $10 billion. (4) Not enough information to answer 19. In a small open economy with perfect capital mobility, an expansionary monetary policy: (1) shifts aggregate supply to the right. (2) shifts aggregate demand to the right. (3) shifts aggregate demand to the right only if the exchange rate is flexible. (4) shifts aggregate demand to the right only if the exchange rate is fixed. 10.8 Assignment 10 continued on the next page
Economic Fluctuations: Effects of Fiscal and Monetary Policy 20. Which of the following is correct concerning how rational people allocate their wealth between money and other assets? (1) As the interest rate falls, people want to hold less money. (2) As the interest rate rises, people want to hold less money. (3) People will want to hold all of their wealth as money since it can be used to buy goods. (4) People will want to hold all of their assets in a form that yields a return. 20 Total Marks Planning Ahead Project 2 is due one week after Assignment 10. By now, you should be well-advanced into the work required for this project. End of Assignment 10 10.9