Overview-chapter 15: MP and FP: Impacts on AD

1. Overview-chapter 15: MP and FP:Impacts on AD • The supply and demand for money including the interest-rate effect on AD • How monetary policy affects the aggregate demand curve. • How fiscal policy affects aggregate demand. Changes in G or T. • Arguments for and against using policy to try to stabilize the economy.

2. Aggregate Demand (AD) • Many factors influence AD, including desired spending by households and business firms. When desired spending changes, shifts in the AD cause short-run fluctuations in output and employment. • Monetary and Fiscal policy can be used to stabilize the economy during these fluctuations. Offset shifts.

3. How Monetary Policy Influences Aggregate Demand • The Aggregate Demand curve is downward sloping due to three effects: • Pigou’s Wealth Effect • Keynes’s Interest-Rate Effect • Real Exchange-Rate Effect • Of these three effects, Keynes’s Interest-Rate Effect and the x-rate effect are most important. • These 2 effects are influenced by MP.

4. Theory of Liquidity Preference (LP): Keynes’s theory: The development of interest rates • LP where liquidity refers to liquid assets-money is the most liquid. • The Liquidity Preference Theory (MD) of interest rates states that “...market rates of interest adjust to balance the supply and demand for money.” • At higher interest rates you want to be less liquid. • Ms determined by B of C

5. Theory of LP • Money demand reflects how much wealth people want to hold in liquid form-as money. • For simplicity, suppose household wealth includes only two assets: • Money – liquid but pays no interest--OC • Bonds – pay 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.

6. Theory of Liquidity Preference: The Supply and Demand for Money • The Money Supply is controlled by the B of C, which alters the money supply in three ways: • Open-Market Operations • Changing the Overnight Rate • Buying and selling Canadian dollars in the market for foreign-currency exchange • The quantity of money supplied in the economy is fixed at whatever level the B of C decides to set it.

7. Theory of Liquidity Preference: The Supply and Demand for Money • Because the money supply is fixed by the B of C it does not depend on the interest rate. • The fixed money supply is represented by a vertical supply curve.

8. The Money Market Interest Rate Money Supply QFixed Quantity of Money

9. Theory of Liquidity Preference: The Supply of Money • By using Open-Market Operations the B of C can shift the vertical money supply curve left or right. • If the B of C buys government bonds: • Bank reserves increase and the money supply increases. • If the B of C sells government bonds: • Bank reserves decrease and the money supply declines.

10. The Money Market Interest Rate Money Supply If the B of C buys government bonds, money supply increases. QFixed Quantity of Money

11. Theory of Liquidity Preference: The Supply and Demand for Money • Money Demand is determined by several factors. However, the most important is the interest rate. • MD= f (Y, r, P) • “People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services.” (i.e. a desire for liquidity)

12. Theory of Liquidity Preference: The Supply and Demand for Money • The primary opportunity cost of having the convenience of holding money is the interest income that one gives up when one holds cash or chequing account balances. • An increase in the interest rate raises the cost of holding money and thus reduces the quantity of money balances people wish to hold.

13. The Money Market Interest Rate Money Demand I0 Quantity of Money Q0

14. Equilibrium in the Money Market • By the Theory of Liquidity Preference: • The interest rate adjusts to balance the supply and demand for money. • There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded exactly equals the quantity of money supplied.

15. Equilibrium in the Money Market Interest Rate Money Supply Money Supply and Money Demand are equal at the equilibrium interest rate. IE Money Demand QFixed Quantity of Money

16. Theory of Liquidity Preference and the Aggregate Demand Curve • The general price level of all goods and services in the economy influences the money demand and interest rates: • A higher price level raises money demand (i.e. a shift in the money demand curve.) • Higher money demand leads to a higher interest rate. • Higher interest rates reduce the quantity of goods and services demanded (AD).

17. Theory of Liquidity Preference and the Aggregate Demand Curve • As interest rates increase, the cost of borrowing and the return to saving is greater. Fewer households and firms borrow money, leading to a decrease in spending. Especially Investment spending. • An increase in the price level causes the real exchange rate to increase and net exports to fall. • The end result is a negative relationship between the price level and the AD.

18. Aggregate Demand Curve and RXR • In an open economy, the other important influence is the real exchange-rate (RXR) effect. • An increase in the price level causes the real exchange rate to increase • Canadian-produced goods are more expensive relative to foreign-produced goods, and both foreigners and Canadians substitute away from Canadian-produced goods • Canada’s net exports fall • This is the RXR effect on slope of AD.

19. Changes in the Money Supply • The B of C has control over shifts in the aggregate demand when it changes monetary policy. Recall: An increase in the money supply (i.e. buying bonds) will... …shift the Money Supply to the right … without a change in the Money Demand the interest rate will fall, thus … inducing people to hold the additional money the B of C has created.

20. Changes in Money Supply Interest Rate MS0 MS1 IE0 IE1 Money Demand Quantity of Money QFixed0 QFixed1

21. Closed Economy • MS ↑ >>r ↓ >>I & consumer durable spending ↑ --shifts Ad so Y ↑ • This is expansionary MP. • However as Y ↑, this increases MD • This partially reverses r ↓ • Overall AD shifts right. • For open economy this is reinforced by RXR ↓ because Rc <Rw

22. Increasing MS-closed economy

23. Small Open Economy Considerations-MP • A monetary injection by the B of C lowers interest rates. • If rc<rw, savers from LF sell C$ and buy ROW. Increases supply of C$ in fx • This causes the dollar to depreciate, which causes net exports to rise shifting the AD curve to the right. • AD shifts farther right than in closed econ.

24. SOE--MP • NX and GDP increase so MD increases driving rc back up to rw. • Major policy effect is through x-rate decline. • The B of C must allow the exchange rate to vary freely if its desire is to change the money supply. • MP more effective because of NX effect

25. MP-Open Economy

26. How Fiscal Policy Influences Aggregate Demand • Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes. • Fiscal policy influences saving, investment, and growth in the long-run. In the short-run, fiscal policy affects aggregate demand. • FP—expansionary and contractionary: ∆G&T

27. Changes in G and T • The federal government can influence the economy because • of the size of the central government in relation to the economy and other economic entities. • of the deliberate use of spending and taxes to manipulate the economy toward achieving a predetermined outcome.

28. MP overview • MS ↑ >>r ↓ >>I & consumer durable spending ↑ --shifts AD right so Y ↑ • This is expansionary MP. • However as Y ↑, this increases MD • This partially reverses r ↓ • Overall AD shifts right. • For SOE this is reinforced by RXR ↓ because Rc <Rw—Supply C$ ↑

29. Changes in G and T--FP • The federal government’s control of the economy is both direct and indirect. • Its expenditures have a direct effect on aggregate spending and therefore equilibrium GDP. • Taxes and tax policy indirectly affect the aggregate spending of consumers. • Expansionary FP is intended to shift AD right.

30. Changes in Government Purchases • There are two macroeconomic effects from government purchases-- ∆G: 1.The Multiplier Effect: SPENDING. 2.The Crowding-Out Effect: Interest rates Crowding out in 2 reduces the effect of 1

31. The Multiplier Effect of Government Purchases • Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar--- a multiplier effect. • The total impact of the quantity of goods and services demanded can be larger than the initial impulse from higher government spending. BECAUSE of re-spending—FIRM & its workers.

32. Spending Multiplier 378-9 • G spends $5000 • Owners and workers receive $5,000 • MPC = ∆C/ ∆Y Eg get $10: spend 8& save 2 • MPC is 0.8 (MPS=0.2) • 1st Extra spending is 0.8*$5000= $4000 • $4000 is income where spent. • They spend 0.8*4000= $3200 etc • Respending gets smaller>>>>>>

33. Spending Multiplier • The formula for the multiplier is: Multiplier (k) = 1 ÷ (1 - MPC) • MPC is the Marginal Propensity to Consume. • MPC = C/ Y Extra C from extra Y • IF MPC= 0.8, k=5 • $5000+4000+3200+2560+------ =$25,000 • $25,000 is k*5000

34. The Multiplier Effect Price Level An increase in government purchases initially increases AD AD2 AD1 Quantity of Output

35. The Multiplier Effect Price Level The multiplier effect can amplify the shift in AD AD3 AD2 AD1 Quantity of Output

36. The Crowding-Out Effect • An increase in government purchases causes the interest rate to rise (MD shifts right) , and a higher interest rate tends to choke off the demand for goods and services. • G competes for LF raising r and reducing I • The reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. • Opposite direction to multiplier.

37. Crowding out by G—MD increases

38. Crowding out • An increase in G increases spending and MD causing interest rates to rise. • The higher interest rates cause interest-sensitive spending (I) to go down and this reduction in demand is called crowding out.

39. Crowding out effects • When G increases its purchases (eg) by $20B, the aggregate demand for goods and services could rise by more or less than $20B depending on whether the multiplier effect or the crowding out effect is larger.

40. FP-Open Economy • Rc=Rw • Initially more G increases Rc--MD • Increases demand for C$ (Rc>Rw) • C$ appreciates • NX falls • FP crowds out NX

41. Open Economy FP-x rate flexible: No lasting effect on AD

42. Changes in Taxes • When the government cuts taxes, it: • Increases households’ take-home pay. This results in households saving some of the additional income---MPS Households will spend some on consumer goods---MPC. This shifts the aggregate-demand curve to the right. Like G spending.

43. Changes in Taxes • The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier and crowding-out effects. • The duration of the shift in the aggregate demand is also determined by the B of C’s policy for the exchange rate (fixed or flexible). NX effect.

44. SOE • In a small, open economy, an expansionary fiscal policy (∆G or ∆ T) causes the dollar to appreciate. Since this causes net exports to fall, there is an additional crowding-out effect that reduces the demand for Canadian produced goods and services.

45. Using Policy to Stabilize the Economy • Many policy-makers believe it necessary to use monetary and fiscal policy to achieve any level of aggregate demand and GDP that they wish. • Active monetary and fiscal intervention is necessary to tame an inherently unstable private sector. • The use of policy instruments stabilizes aggregate demand and production and employment.

46. Using Policy to Stabilize the Economy • The use of government tax and spending policies to stabilize economic ups and downs in the short-run is called discretionary fiscal policy. • Generally, those that accept this approach to short-run economic stabilization follow the Keynesian theory of the economy.

47. Using Policy to Stabilize the Economy • Some economists argue that the government should avoid using monetary and fiscal policy • Policy may make it worse. • The economy can be left to deal with short-run fluctuations on its own. • Discretionary Fiscal policy affects the economy with substantial lags. Effect? • Others: Use MP only-especially SOE.

48. Automatic Stabilizers • Automatic Stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policy-makers having to take any deliberate action. • Automatic stabilizers include: • The Tax System: Y↓ >>T ↓ • Government Spending---EI especially • Flexible X rate.

49. X Rate as Automatic Stabilizer • A U.S. recession would cause Canadian net exports to fall, lowering aggregate demand • However, with flexible exchange rates • Lower Canadian GDP results in lower money demand, reducing the interest rate below the world interest rate • Decreased demand for Canadian assets results in depreciation of the Canadian dollar, making Canadian-produced goods relatively less expensive • Net exports rise

50. The Economy in the Long-Run and Short-Run • When thinking about the long-run economy the Loanable Funds Theory is used to best describe the changes that occur. Rc=Rw S=I • When thinking about the short-run economy, the Liquidity-Preference Theory is used to best describe the changes that occur. ∆Ms>> ∆R>> ∆ Y