Download Fiscal Policy Influences Aggregate Demand

Chapter 32
Influence of Monetary & Fiscal
Policy on Aggregate Demand
How Monetary Policy Influences
Aggregate Demand
• Remember: AD slopes downward b/c of
wealth effect, interest rate effect & exchange
rate effect
• All 3 effects occur simultaneously, but interest
rate effect is most important
Theory of Liquidity Preference
• Keynes’s theory that the interest rate adjusts
to bring money supply and money demand
into balance
- we assume nominal & real interest rates
move together
Money Supply
• Is controlled by Federal Reserve
• Because Fed controls it w/o regard to other
econ. Variables; it’s represented with vertical
supply curve
Money Demand
• Liquidity – how easy asset can be converted
into medium of exchange ($ is most liquid)
• As interest rate rises, the quantity of money
demanded falls – downward sloping demand
• Interest rate adjusts to bring money demand
and money supply into balance
Downward Slope of AD Curve
• When PL increases, people demand more $,
this shifts money demand curve to the right
• With fixed money supply, interest rate must
rise
• With higher interest rate, return on saving
increase so consumers more likely to save and
less likely to invest in new housing
• Therefore, Q of goods & services will fall;
basically explaining interest rate effect
Changes in Money Supply
• Fed buys bonds in open market operations –
will increase supply of money; shifts money
supply to right, interest rate falls & AD shifts
right
Interest Rate Targets
• Monetary policy can be described either in
terms of the money supply or the interest rate
• Fed sometimes targets a specific federal funds
rate (interest rate for banks) rather than a
certain money supply
The Fed & The Stock Market
• Fed will try to stabilize economy by lowering
interest rates when stock market is down and
by raising interest rates when stock market is
soaring
Fiscal Policy & Aggregate Demand
• By changing taxing & spending, it shifts AD
directly
• How much a change in gov’t purchases
increases AD is based on Multiplier effect &
Crowding Out effect
Fiscal Policy Influences Aggregate Demand
• Primary effect of fiscal policy in the short run is on
AD
• If Fed changes money supply, they influence
spending decisions of firms and households and
thereby INDIRECTLY affect AD
• If Govt. changes tax rates, they influence the
spending decisions of firms and households and
thereby INDIRECTLY affect AD
• If Govt. changes its own spending, it DIRECTLY affects
AD
If the Govt. increases spending by $20 billion
dollars, how far does AD shift? To what extent
does GDP increase?
The Multiplier Effect suggests that …….
The shift in AD could be larger than the change
in Govt. spending (larger than $20 b)
GDP
+$20
Increase
Boeing
increases
employment/
income
G buys $20 from Boeing
Increase
Consumer
Spending/
Electronics
Electronics Consumer
Industry.
Spending
hires more
Spending Multiplier
• MPC
• Fraction of extra income that a household
consumes rather than saves
• If MPC = .80…..it means that…….
• For every extra dollar of income the
household earns,
the household will spend 0.80…and
save 0.20
• If MPC is 0.80, then MPS is …..
• 0.20
• If Govt. spends $20b…then that is extra income
for Boeing and they will spend…….
• $16 b and save $4b…..
• and that spending is an extra $16b income for
others, of that they will spend…..
• $12.8 b and save $3.2 b…….
• And that spending is an extra $12.8b income for
others, of that they will spend…..
• $10.24 b and save $2.56b…..and so on and on….
• So the multiplier is 1 / (1-MPC) …. or ….
• 1/MPS
• ……so the original $20 b of increased govt.
spending could generate a total of ……
• $100 b ……..how?
• $20 b initial increase x 1/.20 ….
• $20 b x 5 = $100 b
• COULD?????? Why the word “could” ?
MPC = .80
• What if the govt. purchased $20 b from
Boeing, but instead of expanding production
and labor force, they simply put the $20 b in
savings…….?
• The Multiplier is now 1 and the impact on the
GDP is and increase of only $20 instead of
$100…..
• What if they spent $10b of the $20….?
• The larger the MPC, …the …..
• Larger the Multiplier……..Explain
• Logic of multiplier applies to any component
of AD and GDP
• A small initial change in (C or I or G or Nx)
• Can result in a multiplied effect on AD and
GDP
Change in Taxes
• When the Govt. increase or decrease tax…the
multiplier is applied to the change in spending
• …but must figure out what the change in
spending will be.
• If the govt. cuts tax by $10, it increases DI by
$10…..but…..
• DI is not a part of AD (C,I,G,Nx) …..so…..
• a $10 tax cut will increase C by ……
• Tax x MPC …… logic…
• If you now have $10 extra, you will not spend
all of it, but rather you will spend a % of the
additional income based on MPC….so…..
• Tax cut $10 = increase C by ($10 x MPC .80) =
$8 and increase savings by $2
• Now can apply multiplier to increase in
amount of C , and NOT the size of the tax
If MPC = .80
Tax cut $10 =
Increase DI $10=
Increase C $8
Increase GDP $40
Crowding Out Effect
Crowding Out Effect
• If gov’t uses fiscal policy to expand (lowers
taxes, increases spending) it will have
multiplier effect on AD, but it also will cause
interest rate to rise
• This rise in interest rate will decrease
investment, which lowers AD thereby
“crowding out” some of the growth (gov’t
spending crowds out investment spending)
Crowding Out
G increase spending 
AD shifts rt.
money market 
MD shifts right 
IR rise 
Inv. Decreases
AD shifts left
G = AD shift right
But also causes IR to rise and lowers Inv and AD
As G increases spending, the resulting increase in IR
“CROWDS OUT” Investment and prevents AD
from expanding as much as intended.
Can PREVENT expansionary fiscal policy from
reaching its goal.
• Consider “Crowding In” effect
• Nx effect