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 Unit 5 How Monetary Policy Influences Aggregate Demand ● The aggregate-demand curve slopes downward for three reasons ○ The Wealth Effect​- A lower price level raises the real value households’ money holdings, and higher real wealth stimulates consumer spending ○ The Interest-Rate Effect- ​A lower price level lowers the interest rate as individuals try to lend out their excess money holdings, and the lower interest rate stimulates investment spending ○ The Exchange-Rate Effect-​When a lower price level lowers the interest rate, investors move some of their funds overseas and cause the domestic currency depreciate relative to foreign currencies. This depreciation makes domestic goods cheaper compared to foreign goods and, therefore, stimulates spending on net exports ● These three effects occur simultaneously to increase the quantity of goods and services demanded when the price level falls and to decrease it when the price level rises. ● THE MOST IMPORTANT REASON FOR THE DOWNWARD SLOPE OF THE AGGREGATE DEMAND CURVE IS THE INTEREST-RATE EFFECT The Theory of Liquidity Preference ● The Theory of Liquidity Preference- Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance ○ Economists distinguish between two interest rates ■ Nominal Interest Rates- Interest Rate that is usually reported ■ Real Interest Rates- Interest rate corrected for inflation ○ Which Interest Rate are we talking about? The answer is ​both ○ For the rest of this study guide, any change in the interest rate should be envisioned as the nominal and real interest rates moving in the same direction 2 Money Supply ● The first piece of the theory of liquidity preference is the supply of money ○ The fed alters the money supply primarily by changing the quantity of reserves in the banking system through the purchase and sale of government bonds in open-market operations ■ The can also alter money supply by changing reserve requirements or discount loans ● ASSUME THAT THE FED CONTROLS THE MONEY SUPPLY DIRECTLY ○ The quantity of money supplied in the economy is fixed at whatever level the Fed decides ○ The money supply, therefore, does not get affected by interest rates Money Demand ● Any assets ​liquidity​ refers to the ease with which that asset is converted into the economy’s medium of exchange ○ Money is the economy’s medium of exchange (most liquid) ● The interest rate is the opportunity cost of holding money ○ An increase in the interest rate raises the cost of holding money, which in turn decreases the quantity of money demanded ○ A decrease in the interest rate reduces the cost of holding money which causes an increase in the quantity of money demanded ■ THIS IS WHY THE MONEY DEMAND CURVE IS DOWNWARD SLOPING Equilibrium in the Money Market ● The interest rate adjusts to balance the supply and demand for money ● Equilibrium Interest Rate- ​The quantity of money demanded exactly balances the quantity of money supplied ○ If the interest rate is at any other level, people will adjust their portfolios which will drive the I.R. to equilibrium 3 The Downward Slope of the Aggregate Demand Curve ● The interest rate effect can be summarized in three steps a. A higher price level raises money demand b. Higher money demand leads to a higher interest rate c. A higher interest rate reduced the quantity of goods and services demanded ■ Same logic works in reverse as well Changes in the Money Supply ● When the fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the right. Conversely, when the Fed contracts the money supply, it raises the interest rates and reduces the quantity of goods and services demanded for any given price level, shifting the aggregate demand curve to the left. The Role of Interest-Rate Targets in Fed Policy ● Federal Funds Rate- the interest rate that banks charge on another for short term loans ○ This ​target​ is reevaluated every six weeks at meetings of the FOMC ● The Fed’s decision to target an interest rate does not fundamentally alter our analysis of monetary policy ○ Monetary policy can be described either in terms of the money supply or in the terms of the interest rate ■ Changes in monetary policy can be viewed in terms of a changing target for the interest rate ○ Changes in monetary policy that aim to expand aggregate demand can be described as increasing money supply or as lowering the interest rate ■ The same can be said for the reverse 4 How Fiscal Policy influences Aggregate Demand Changes in Government Purchases ● When the government alters its own purchases of goods and services, it directly shifts aggregate demand ● There are two macroeconomic effects that make the size of the shift in AD differ from the changes in government purchases: The Multiplier Effect and The Crowding Out Effect The Multiplier Effect ● Multiplier Effect- The addition shifts in Aggregate Demand that result when expansionary fiscal policy increases income thereby increases consumer spending ○ Higher earnings stimulate consumer spending. The firms that produce the goods demanded hire more people and experience higher profits. Thus, there is a positive feedback as higher demand leads to higher income which then leads to higher demand. ○ This multiplier effect can be strengthened by the response of investment to higher levels of demand. This is called ​Investment Accelerator. A Formula for the Spending Multiplier ● Marginal Propensity to Consume (MPC)- The fraction of extra income that a household consumes rather than saves. ● Marginal Propensity to Save (MPS)- The fraction of extra income that a household saves rather than consumes. ● Multiplier= 1/(1-MPC) ● Multiplier= 1/(MPS) Other Applications of the Multiplier Effect ● The multiplier effect applies to any event that alters spending on any component of GDP (consumption, investment, government purchases, net exports) ○ Important concept because it shows how the economy can amplify the impact of changes in spending. 5 The Crowding-Out Effect ● Crowding out effect- the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending ● An increase in the interest rate, reduced the quantity of goods and services demanded. Because borrowing is more expensive, the demand for investment goods decline. ○ As government purchases increase, it may crowd out investment ● When the government increases its purchases by $20 billion, the aggregate demand for goods and services could raise bt more or less than $20 billion, depending on whether the multiplier effect ot the crowding out effect is larger. Changes in Taxes ● When the government cuts personal income taxes, it increases take home pay. Households will save some of this additional income, but they will also spend more on consumer goods. Because it increases consumer spending, tax cuts shift the aggregate demand curve to the right ○ The size of the shift in the AD curve resulting from tax change is also affected by the multiplier and crowding out effects. ■ When governments cut taxes and stimulates consumer spending, earnings and profits rise, which furthers consumer spending. This is the multiplier effect. ■ At the same time, higher income leads to higher money demanded, which tends to raise interest rates. Higher interest rates make borrowing more costly, which reduces investment spending. This is the crowding out effect. ● Household perceptions about whether the tax change is permanent or temporary also is a determinant of the size of the shift. ○ If the government announces a tax cut , households will ask themselves how long this tax cut will hold. If households expect the tax cut to be permanent, they will view it as adding substantially to their financial resources which will increase consumer spending. 6 Using Policy to Stabilize the Economy The Case for Active Stabilization Policy ● Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946​. This act states that “it is the continuing policy and responsibility of the federal government to...promote full employment and production.” ○ The employment act has two implications: Government should avoid being the cause of economic fluctuations. ■ Many economists advise against large and sudden changes in monetary or fiscal policy ○ The second implication: Governments should respond to changes in the private economy in order to stabilize aggregate demand ■ Government should actively simulate aggregate demand when the aggregate demand appeared insufficient to maintain production at its full employment level The Case Against Stabilization Policy ● Some economists claim that these policy instruments affect the economy with substantial lag. Most economists believe that that it takes at least six months for changes in monetary policy to have much of an effect on employment and output. ○ Critics arge that because of the lag, the Fed should not try to fine tune the economy ○ They argue that the Fed reacts too late to changing economic conditions ■ These critics advocate for passive monetary policy ● In the United States, most changes in government spending and taxes must go through congressional committees, be passed by both legislative parties and then be signed by the president. Completing this process can take up to years. By that time the change in fiscal policy is passed, but the condition of the economy has also changed. This adds on to the entire lag. 7 Automatic Stabilizers ● Automatic Stabilizers- Changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action ○ The most important Automatic Stabilizer is the tax system. ■ When the economy goes into a recession, the amount of taxes collected decreases automatically, because almost all taxes are closely tied to economic activity. ● Because incomes, earning, and profits all fall in a recession, the government’s tax revenue also falls ■ This automatic tax cut stimulates aggregate demand which reduces the magnitude of economic fluctuations ○ Government spending is another automatic stabilizer ■ When the economy goes into a recession and workers are laid off, more people apply for unemployment insurance benefits, welfare benefits, and other forms of income support. This automatic stabilizer increases government spending which stimulates aggregate demand at exactly the time in which the aggregate demand is insufficient to maintain the full employment level. ● A strict balanced budget rule would eliminate the automatic stabilizers inherent in our current system of taxes and government spending.