Download 34 The Influence of Monetary and Fiscal Policy on Aggregate Demand

CHAPTER
34
The Influence of Monetary
and Fiscal Policy on Aggregate
Demand
Goals
in this chapter you will
Learn the theory of liquidity preference as a short-run theory of
the interest rate
Analyze how monetary policy affects interest rates and aggregate
demand
Analyze how fiscal policy affects interest rates and aggregate
demand
Discuss the debate over whether policymakers should try to
stabilize the economy
Outcomes
after accomplishing
these goals, you
should be able to
Show what an increase in the money supply does to the interest
rate in the short run
Illustrate what an increase in the money supply does to aggregate
demand
Explain crowding out
Describe the lags in fiscal and monetary policy
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Chapter 34 The Influence of Monetary and Fiscal Policy on Aggregate Demand
Strive for a Five
The information presented in Chapter 34 will be tested on the AP macroeconomics exam
and can be up to 20 percent of the multiple-choice section. This material has recently been
tested in the free-response portion as well. This means you should be prepared to show
changes in monetary and fiscal policies and their impact on the economy as shown in the
aggregate supply and demand model. Additional topics relevant to the AP macroeconomics
exam are:
■■ Fiscal and monetary policy
■■ Individual effects of the two stabilization policies
■■ Combining the policies
■■ Spending multiplier
■■ Tax multiplier
■■ The crowding-out effect
■■ Automatic stabilization
Key Terms
■■
■■
■■
■■
■■
■■
■■
■■
■■
■■
Theory of liquidity preference—Keynes’s theory that the interest rate is determined by the
supply and demand for money in the short run
Liquidity—The ease with which an asset is converted into a medium of exchange
Federal funds rate—The interest rate banks charge one another for short-term loans
Fiscal policy—The setting of the level of government spending and taxation by
government policymakers
Multiplier effect—The amplification of the shift in aggregate demand from
expansionary fiscal policy, which raises incomes and further increases consumption
expenditures
Investment accelerator—The amplification of the shift in aggregate demand from
expansionary fiscal policy, which raises investment expenditures
Marginal propensity to consume (MPC)—The fraction of extra income that a household
spends on consumption
Crowding-out effect—The dampening of the shift in aggregate demand from
expansionary fiscal policy, which raises the interest rate and reduces investment
spending
Stabilization policy—The use of fiscal and monetary policies to reduce fluctuations in
the economy
Automatic stabilizers—Changes in fiscal policy that do not require deliberate action on
the part of policymakers
Chapter Overview
Context and Purpose
Chapter 34 is the second chapter in a three-chapter sequence that concentrates on shortrun fluctuations in the economy around its long-term trend. In Chapter 33, we introduced
the model of aggregate supply and aggregate demand. In Chapter 34, we see how the
government’s monetary and fiscal policies affect aggregate demand. In Chapter 35, we will
see some of the trade-offs between short-run and long-run objectives when we address the
relationship between inflation and unemployment.
The purpose of Chapter 34 is to address the short-run effects of monetary and fiscal
policies. In Chapter 33, we found that when aggregate demand or short-run aggregate
Chapter 34
the influenCe of monetary and fisCal PoliCy on aggregate demand
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. Chapter
34 addresses the theory behind these policies and some of the shortcomings of stabilization
policy.
Chapter Review
Introduction Chapters 25 through 30 demonstrated the impact of fiscal and monetary
policy on saving, investment, and long-term growth. Chapter 33 demonstrated that shifts
in aggregate demand and short-run aggregate supply cause short-run fluctuations in the
economy around its long-term trend and how monetary and fiscal policymakers might
shift aggregate demand to stabilize the economy. In this chapter, we address the theory
behind stabilization policies and some of the shortcomings of stabilization policy.
How Monetary Policy Influences Aggregate Demand
The aggregate-demand curve shows the quantity of goods and services demanded at each
price level. Recall from Chapter 33 that aggregate demand slopes downward due to the
wealth effect, the interest-rate effect, and the exchange-rate effect. Since money is a small
part of total wealth and since the international sector is a small part of the U.S. economy,
the most important reason for the downward slope of U.S. aggregate demand is the
interest-rate effect.
The interest rate is a key determinant of aggregate demand. To see how monetary policy
affects aggregate demand, we develop Keynes’s theory of interest rate determination called
the theory of liquidity preference. This theory suggests that the interest rate is determined
by the supply and demand for money. Note that the interest rate being determined is
both the nominal and the real interest rate because, in the short run, expected inflation is
unchanging so changes in the nominal rate equal changes in the real rate.
Recall, the money supply is determined by the Fed and can be fixed at whatever
level the Fed chooses. Therefore, the money supply is unaffected by the interest rate and
is a vertical line in Exhibit 1. People have a demand for money because money, as the
economy’s most liquid asset, is a medium of exchange. Hence, people have a demand for
it even though it has no rate of return because it can be used to buy things. The interest
rate is the opportunity cost of holding money. When the interest rate is high, people hold
more wealth in interest-bearing bonds and economize on their money holdings. Thus,
the quantity of money demanded is reduced. This is shown in Exhibit 1. The equilibrium
interest rate is determined by the intersection of money supply and money demand.
Money
Supply
1
Interest Rate
EXHIBIT
Equilibrium
Interest Rate
Money
Demand
Quantity
Fixed by
Fed
Quantity
of Money
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Chapter 34
the influenCe of monetary and fisCal PoliCy on aggregate demand
Note that, in the long run, the interest rate is determined by the supply and demand for
loanable funds. In the short run, the interest rate is determined by the supply and demand
for money. This poses no conflict.
■■
■■
In the long run, output is fixed by factor supplies and technology, the interest rate
adjusts to balance the supply and demand for loanable funds, and the price level
adjusts to balance the supply and demand for money.
In the short run, the price level is sticky and cannot adjust. For any given price level,
the interest rate adjusts to balance the supply and demand for money. The interest rate
influences aggregate demand and thus output.
Each theory highlights the behavior of interest rates over a different time horizon.
We can use the theory of liquidity preference to add precision to our explanation of
the negative slope of the aggregate-demand curve. Recall from previous chapters, the
demand for money is positively related to the price level because at higher prices, people
need more money to buy the same quantity of goods. Thus, a higher price level shifts
money demand to the right, as shown in Exhibit 2, panel (a). With a fixed money supply,
a larger money demand raises the interest rate. A higher interest rate reduces investment
expenditures and causes the quantity demanded of goods and services to fall in Exhibit 2,
panel (b).
Returning to the point of this section: How does monetary policy influence aggregate
demand? Suppose the Fed buys government bonds shifting the money supply to the
right, as in Exhibit 3, panel (a). The interest rate falls, reducing the cost of borrowing
for investment. Hence, the quantity of goods and services demanded at each price level
increases, shifting aggregate demand to the right in Exhibit 3, panel (b).
The Fed can implement monetary policy by targeting the money supply or interest
rates. In recent years, the Fed has targeted the interest rate because the money supply is
hard to measure and because money demand fluctuates, causing fluctuations in interest
rates, aggregate demand, and output for a given money supply. In particular, the Fed has
targeted the federal funds rate—the interest rate banks charge each other for short-term
loans. Whether the Fed targets the money supply or interest rates has little effect on our
analysis because every monetary policy can be described in terms of the money supply or
EXHIBIT
2
Price Level
Money
Supply
Interest Rate
346
Aggregate Demand
P2
r2
P1
M2d(P2)
r1
M1d(P1)
Quantity
Fixed by
Fed
Panel (a)
Quantity
of Money
Y2
Y1
Quantity
of Real
Output
Panel (b)
Chapter 34
3
M2s
Price Level
M1s
Interest Rate
EXHIBIT
the influenCe of monetary and fisCal PoliCy on aggregate demand
P
r1
r2
AD2
)
M d(P
Quantity
of Money
Panel (a)
Y1
Y2
Panel (b)
AD1
Quantity
of Real
Output
the interest rate. For example, the monetary policy expansion used to increase aggregate
demand in the example above could be described as an increase in the money supply or a
decrease in the interest rate target.
How Fiscal Policy Influences Aggregate Demand
Fiscal policy refers to the government’s choices of the levels of government purchases and
taxes. While fiscal policy can influence growth in the long run, its primary impact in the
short run is on aggregate demand.
An increase in government purchases of $20 billion to buy military aircraft is reflected
in a rightward shift in the aggregate-demand curve. There are two reasons why the actual
rightward shift may be greater than or less than $20 billion:
■■
The multiplier effect: When the government spends $20 billion on aircraft, incomes
rise in the form of wages and profits of the aircraft manufacturer. The recipients of
the new income raise their spending on consumer goods, which raises the incomes
of people in other firms, which raises their consumption spending, and so on for
many rounds. Since aggregate demand may rise by much more than the increase
in government purchases, government purchases are said to have a multiplier effect
on aggregate demand. There is a formula for the size of the multiplier effect. It says
that for every dollar the government spends, aggregate demand shifts to the right by
1/(1 – MPC), where MPC stands for the marginal propensity to consume—the fraction
of extra income that a household spends on consumption. For example, if the MPC is
0.75, the multiplier is 1/(1 – 0.75) = 1/0.25 = 4, which means that $1 of government
spending shifts aggregate demand to the right by a total of $4. An increase in the MPC
increases the multiplier.
In addition to the multiplier, the increase in purchases may cause firms to increase
their investment expenditures on new equipment, further increasing the response of
aggregate demand to the initial increase in government purchases. This is known as
the investment accelerator.
Thus, the aggregate-demand curve may shift by more than the change in
government purchases.
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Chapter 34 The Influence of Monetary and Fiscal Policy on Aggregate Demand
The logic of the multiplier effect applies to other changes in spending besides
government purchases. For example, shocks to consumption, investment, and net
exports may have a multi­plier effect on aggregate demand.
■■
The crowding-out effect: The crowding-out effect works in the opposite direction of
the multiplier. An increase in government purchases (as in the case above) raises
incomes, which shifts the demand for money to the right. This raises the interest rate,
which lowers investment. Thus, an increase in government purchases increases the
interest rate and reduces, or crowds out, private investment. Due to crowding out,
the aggregate-demand curve may shift right by less than the increase in government
purchases.
Whether the final shift in the aggregate-demand curve is greater than or less than the
original change in government spending depends on which is larger: the multiplier effect
or the crowding-out effect.
The other half of fiscal policy is taxation. A reduction in taxes increases households’
take-home pay and, hence, increases their consumption. Thus, a decrease in taxes shifts
aggregate demand to the right while an increase shifts aggregate demand to the left. The
size of the shift in aggregate demand depends on the relative size of the multiplier and
crowding-out effects described above. In addition, a reduction in taxes that is perceived
by households to be permanent improves the financial condition of the household a great
amount and increases aggregate demand substantially. A change in taxes that is perceived to
be temporary has a much smaller effect on aggregate demand.
Finally, fiscal policy might have an effect on aggregate supply for two reasons. First,
a reduction in taxes might increase the incentive to work and cause aggregate supply to
shift right. Supply-siders believe this effect could be so large that tax revenue could increase.
Most economists do not believe this is the normal case. Second, government purchases
of capital, such as roads and bridges, may increase the amount of goods supplied at each
price level and shift the aggregate-supply curve to the right. This effect is more likely to be
important in the long run.
Using Policy to Stabilize the Economy
Keynes (and his followers) argued that the government should actively use monetary and
fiscal poli­cies to stabilize aggregate demand and, as a result, output and employment.
The Employment Act of 1946 holds the federal government responsible for promoting
full em­ployment and production. The act has two implications: (1) The government should
not be the cause of fluctuations, so it should avoid sudden changes in fiscal and monetary
policy, and (2) the gov­ernment should respond to changes in the private economy in order
to stabilize it. For example, if consumer pessimism reduces aggregate demand, the proper
amount of expansionary monetary or fiscal policy could stimulate aggregate demand to
its original level, thereby avoiding a recession. Alternatively, if excessive optimism increases
aggregate demand, contractionary monetary or fiscal policy could dampen aggregate
demand to its original level, thereby avoiding inflationary pres­sures. Failure to actively
stabilize the economy may allow for unnecessary fluctuations in output and employment.
Some economists argue that the government should not use monetary and fiscal policy
to try to stabilize short-run fluctuations in the economy. While they agree that, in theory,
activist policy can stabilize the economy, they feel that, in practice, monetary and fiscal
policy affect the economy with a substantial lag. The lag for monetary policy is at least
six months, so it may be hard for the Fed to “fine-tune” the economy. Fiscal policy has a
long political lag because it takes months or years to pass spending and taxation legislation.
These lags mean that activist policy could be destabilizing because expansionary policy
could accidentally increase aggregate demand during periods of excessive pri­vate aggregate
demand, and contractionary policy could accidentally decrease aggregate demand during
periods of deficient private aggregate demand.
Automatic stabilizers are changes in fiscal policy that automatically stimulate aggregate
demand in a recession so that policymakers do not have to take deliberate action. The tax
system automati­cally lowers tax collections during a recession when incomes and profits
fall. Government spending automatically rises during a recession because unemployment
Chapter 34 The Influence of Monetary and Fiscal Policy on Aggregate Demand
benefits and welfare payments rise. Hence, both the tax and government spending systems
increase aggregate demand during a reces­sion. A strict balanced budget rule would
eliminate automatic stabilizers because the government would have to raise taxes or lower
expenditures during a recession.
Helpful Hints
1. The multiplier can be derived in a variety of different ways.Your text shows you
that the value of the multiplier is 1/(1 – MPC). However, it doesn’t show you how
this number is generated. Below, you will find one of the many different ways that
the value of the multiplier can be derived for the case of an increase in government
spending:
∆output demanded = ∆spending on output,
which says that the change in output demanded equals the change in spending on
output. Denot­ing Y as output demanded, G as government spending, and noting that
output equals income, then
∆Y = ∆G + [(MPC) × ∆Y],
which says that the change in output demanded is equal to the change in total
spending where total spending is composed of the change in government spending
plus the change in consump­tion spending induced by the increase in income (say 0.75
of the change in income).
Solving for ∆Y, we get
∆Y – [(MPC) × ∆Y] = ∆G
∆Y × (1 – MPC) = ∆G
∆Y = 1/(1 – MPC) × ∆G,
which says that a $1 increase in government spending causes an increase in aggregate
demand of 1/(1 – MPC) × $1. If the MPC equals 0.75, then 1/(1 – 0.75) = 4 and a
$1 increase in government spending shifts aggregate demand to the right by $4.
2. An increase in the MPC increases the multiplier. If the MPC were 0.80, suggesting
that people spend 80 percent of an increase in income on consumption goods, the
multiplier would become 1/(1 – 0.80) = 5. This is larger than the multiplier generated
above from an MPC of 0.75. There is an intuitive appeal to this result. If people
spend a higher percentage of an increase in income on consumption goods, any new
government purchase will have an even larger multiplier effect and shift the aggregatedemand curve further to the right.
3. The multiplier works in both directions. If the government reduces purchases, the
multiplier ef­fect suggests that the aggregate-demand curve will shift to the left by
a greater amount than the initial reduction in government purchases. When the
government reduces purchases, wages and profits of people are reduced and they
reduce their consumption expenditures, and so on, creat­ing a multiple contraction in
aggregate demand.
4. Activist stabilization policy has many descriptive names. Activist stabilization policy
is the use of discretionary monetary and fiscal policies to manage aggregate demand
in such a way as to minimize the fluctuations in output and to maintain output at
the long-run natural rate. As such, activist stabilization policy is sometimes called
discretionary policy to distinguish it from automatic stabilizers. It is also called aggregate
demand management because monetary and fiscal policies are used to adjust or manage
total spending in the economy. Finally, since policymakers attempt to counter the
business cycle by reducing aggregate demand when it is too high and by increasing
aggregate demand when it is too low, stabilization policy is sometimes referred to as
countercyclical policy.
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Chapter 34 The Influence of Monetary and Fiscal Policy on Aggregate Demand
5. Activist stabilization policy can be used to move output toward the long-run natural
rate from levels of output that are either above or below the natural rate of output.
As in the previous chapter, most of the examples of stabilization policy in the text
assume the economy is in a reces­sion—a period when output is below the long-run
natural rate. However, activist stabilization policy can be used to reduce aggregate
demand and output in periods when output exceeds the long-run natural rate. When
output exceeds the natural rate, we sometimes say that the economy is in a boom,
an expansion, or that the economy is overheating. When the economy’s output is
above the natural rate, the economy is said to be overheating because, left alone, the
economy will adjust to a higher level of expected prices and wages and output will
fall to the natural rate (short-run aggregate supply shifts left). Most economists believe
that the Federal Reserve needs political independence to combat an overheating
economy. This is because the activist policy prescription for an overheating economy
is a reduction in aggregate demand, which usually faces political opposition. That is,
“taking away the punch bowl just as the party gets going” is not likely to be politically
popular.
Self-Test
Multiple-Choice Questions
1. Which of the following explain the shape of the aggregate-demand curve?
a. wealth effect and interest-rate effect
b. exchange-rate effect and substitution effect
c. substitution effect and interest-rate effect
d. substitution effect and complement effect
e. income effect and substitution effect
2. In recent years, the Federal Reserve has conducted policy by setting a target for the
a. size of the money supply.
b. growth rate of the money supply.
c. federal funds rate.
d. discount rate.
e. prime rate.
3. While a television news reporter might state that “Today the Fed lowered the federal
funds rate from 5.5 percent to 5.25 percent,” a more precise account of the Fed’s
action would be as follows:
a. “Today the Fed told its bond traders to conduct open-market operations in such
a way that the equilibrium federal funds rate would decrease to 5.25 percent.”
b. “Today the Fed lowered the discount rate by a quarter of a percentage point, and
this action will force the federal funds rate to drop by the same amount.”
c. “Today the Fed took steps to decrease the money supply by an amount that is
sufficient to decrease the federal funds rate to 5.25 percent.”
d. “Today the Fed took a step toward contracting aggregate demand, and this was
done by lowering the federal funds rate to 5.25 percent.”
e. “Today the Fed directly lowered the equilibrium federal funds rate from 5.5
percent to 5.25 percent.”
4. If expected inflation is constant, then when the nominal interest rate increases, the real
interest rate
a. increases by more than the change in the nominal interest rate.
b. increases by the change in the nominal interest rate.
c. decreases by the change in the nominal interest rate.
d. decreases by more than the change in the nominal interest rate.
e. does not change.
Chapter 34 The Influence of Monetary and Fiscal Policy on Aggregate Demand
5. Which combination of the following Fed actions would increase the money supply
the most?
open-market action discount rate reserve requirement
A.
sell
increase
increase
B.
buy
increase
increase
C.
buy
decrease
decrease
D.
sell
decrease
decrease
E.
sell
decrease
increase
a. A.
b. B.
c. C.
d. D.
e. E.
6. The opportunity cost of holding money
a. decreases when the interest rate increases, so people desire to hold more of it.
b. decreases when the interest rate increases, so people desire to hold less of it.
c. increases when the interest rate increases, so people desire to hold more of it.
d. increases when the interest rate increases, so people desire to hold less of it.
e. increases when the interest rate decreases, so people desire to hold less of it.
Figure 34-1
On the left-hand graph, MS represents the supply of money and MD represents the
demand for money; on the right-hand graph, AD represents aggregate demand. The usual
quantities are measured along the axes of both graphs.
MS
r2
r1
P2
P1
MD2
AD
MD1
Y2
Y1
7. Refer to Figure 34-1. What is measured along the horizontal axis of the left-hand
graph and the right-hand graph respectively?
a. nominal output and the quantity of money
b. real output and the quantity of money
c. the opportunity cost of holding money and real GDP
d. the quantity of money and real GDP
e. the interest rate and the price level
8. The interest rate falls if
a. either money demand or money supply shifts right.
b. money demand shifts right or money supply shifts left.
c. either money demand or money supply shifts left.
d. money demand shifts left or money supply shifts right.
e. money demand shifts right along a vertical money supply curve.
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Chapter 34 The Influence of Monetary and Fiscal Policy on Aggregate Demand
9. Other things equal, in the short run a higher price level leads households to
a. increase consumption, firms to buy more capital goods, and GDP to increase.
b. increase consumption, firms to buy fewer capital goods, and GDP to decrease.
c. decrease consumption, firms to buy more capital goods, and GDP to increase.
d. decrease consumption, firms to buy fewer capital goods, and GDP to decrease.
e. decrease consumption, firms to buy more capital goods, and GDP to remain the
same.
10. Which of the following shifts aggregate demand to the right?
a. an increase in the price level
b. an increase in the money supply
c. a decrease in the price level
d. a decrease in the money supply
e. a decrease in the money supply with a decrease in the price level
11. If the Fed conducts open-market sales,
a. the money supply increases, aggregate demand shifts right, and GDP increases.
b. the money supply increases, aggregate demand shifts left, and GDP decreases.
c. the money supply decreases, aggregate demand shifts right, and GDP decreases.
d. the money supply decreases, aggregate demand shifts left, and GDP decreases.
e. the money supply decreases, aggregate demand shifts right, and GDP increases.
12. Suppose the MPC is 0.75. There are no crowding out or investment accelerator effects.
If the government increases its expenditures by $200 billion, then by how much does
aggregate demand shift to the right? If the government decreases taxes by $200 billion,
then by how far does aggregate demand shift to the right?
a. $800 billion and $800 billion
b. $800 billion and $600 billion
c. $600 billion and $600 billion
d. $600 billion and $450 billion
e. $450 billion and $450 billion
Free Response Questions
1. Explain how unemployment insurance acts as an automatic stabilizer.
2. Suppose that the government increases expenditures by $150 billion while increasing
taxes by $150 billion. Suppose that the MPC is 0.80 and that there are no crowding
out or accelerator effects. What are the combined effects of these changes? Why is the
combined change not equal to zero?
Chapter 34 The Influence of Monetary and Fiscal Policy on Aggregate Demand
Solutions
Multiple-Choice Questions
1. a TOP: Aggregate-demand curve
2. c TOP: Federal funds rate | Monetary policy
3. a TOP: Federal funds rate | Monetary policy
4. b TOP: Nominal interest rate | Real interest rate
5. c TOP: Money supply
6. d TOP: Money demand
7. d TOP: Money market
8. d TOP: Money market
9. d TOP: Interest-rate effect
10. b TOP: Aggregate demand shifts
11. d TOP: Open-market operations | Aggregate demand shifts
12. b TOP: Multiplier | Taxes
Free Response Questions
1. As income falls, unemployment rises. More people will apply for unemployment compensation from the
government, which raises government spending.An increase in government spending tends to increase aggregate
demand, output, and income, thereby lessening the effects of the recession.
TOP: Automatic stabilizers
2. The multiplier is 1/(1-MPC) = 1/(1-.8) = 1/.2 = 5. The increase of $150 in government expenditures leads
to a shift of $150 billion x 5 = $750 billion in aggregate demand. The increase in taxes decreases income by
$150 and so initially decreases consumption by $150 billion x MPC = $150 billion x .8 = $120 billion. This
change in consumption will create a multiplier effect of $120 billion x 5 = $600. Thus, the net change is $750
billion - $600 billion = $150 billion. The changes do not cancel each other out because a tax increase decreases
consumption by less than the tax increase.
TOP: Multiplier effect | Taxes
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