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Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand
Principles of Economics, 7th Edition
N. Gregory Mankiw
Page 1
1. Introduction
a.
In this chapter we examine in more detail how the government’s tools of
monetary and fiscal policy influence the position of the AD curve.
2. How Monetary Policy Influences Aggregate Demand
a.
While all three of the theories about the AD curve being negatively sloped are
relevant, for the US economy the most important reason for the downward slope
of the AD curve is the interest rate effect.
b.
The theory of liquidity preference is Keynes’s theory that the interest rate adjusts
to bring money supply and money demand into balance. P. 747.
i.
Mankiw is kind as Keynes’ theory of the interest rate rejected the principles
of microeconomics and is somewhere between wrong and confusing.
ii.
People like Milton Friedman have maintained the essential role of
microeconomics as applied to all markets.
iii. Remember, money is a highly liquid asset that facilitates transactions.
(1) People react to its cost, the interest rate available on other assets,
and income, because it is a normal good.
iv. In this analysis, there is no inflation so the nominal and real interest rates are
the same.
v.
There is an excellent discussion of the process by which the FR increases
the money supply.
vi. The money supply, which is controlled by the Federal Reserve, is vertical as
the Fed is not influenced by the interest rate.
(1) Figure 1: Equilibrium in the Money Market. P. 748.
vii. The public’s demand for money--as for all normal goods-- is negatively
related to its price (the nominal rate of interest) and positively related to
their nominal incomes.
viii. Equilibrium in the Money Market
ix. FYI: Interest Rates in the Long Run and the Short Run, P. 750.
(1) This is excellent summary of the short run and long run forces in the
economy.
(2) In the long run:
(a) Output is determined by real factors.
(b) The interest rate adjusts to balance the supply and demand for
loanable funds.
(c) The price level adjusts to balance the supply and demand for
money.
(3) In the short run:
(a) The price level is stuck,
(b) The interest rate adjusts to balance the supply and demand for
money and
(c) The level of output responds to the aggregate demand for goods
Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand
Principles of Economics, 7th Edition
N. Gregory Mankiw
Page 2
c.
d.
e.
and services.
The Downward Slope of the Aggregate Demand Curve
i.
A higher price level raises money demand,
ii.
The higher money demand leads to a higher interest rate and
iii. The higher interest rate reduces th quantity of goods and services
demanded.
(1) Figure 2: The Money Market and the Slope of the AD Curve.
P. 751.
Changes in the Money Supply Shift the AD Curve.
i.
A monetary injection by the Fed increases the money supply.
ii.
For any given price level, a higher money supply leads to a lower interest
rate, which in turn increases the quantity of goods and services demanded.
iii. Figure 3: A Monetary Injection. P. 752.
iv. 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 AD curve to the right.
v.
Conversely, when the Fed contracts the money supply, it raises the interest
rate and reduces the quantity of goods and services demanded, for any given
price level shifting the AD curve to the left.
The Role of Interest-Rate Targets and Fed Policy
i.
Monetary policy can be described either in terms of the money supply or in
terms of the interest rate.
ii.
The Fed can control the money supply or interest rate, but not both.
iii. While the recent past has been a period of relative stability, stable interest
rates tend to be pro-cyclical rather than counter-cyclical--which should be
the focus of macroeconomic policy.
(1) The prefer policy would cause interest rates to fall during recessions
and increase during booms.
(2) FYI: The Zero Lower Bound, P. 753.
iv. Case Study: Why the Fed Watches the Stock Market (and Vice Versa),
P. 754.
3. How Fiscal Policy Influences Aggregate Demand
a. Fiscal policy refers to the government’s choices regarding the overall level of
government purchases and taxes. P. 755.
b.
There are two macroeconomic effects that make the size of the shift in AD differ
from the change in G.
i.
The Multiplier Effect and
ii.
The Crowding-out Effect
c.
Changes in Government Purchases Can Have a Multiplier Effect.
i.
This effect is too unpredictable to be used for policy purposes.
(1) It is also neutralized by the following effect.
Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand
Principles of Economics, 7th Edition
N. Gregory Mankiw
Page 3
ii.
d.
Multiplier effect is the additional shifts in aggregate demand that result
when expansionary fiscal policy increase income and thereby increases
consumer spending. P. 756.
iii. A Formula for the Government-Purchases Multiplier
(1) Multiplier = (1/(1 - MPC)
(2) Figure 4: The Multiplier Effect. P. 756.
iv. Other Applications of the Multiplier Effect.
v.
Crowding out Effect.
(1) The offset in AD that results when expansionary fiscal policy raises
the interest and thereby reduces investment spending.
(2) This was somewhat clearer in the loanable funds market discussed in
Chapter 26.
(3) The multiplier effect is usually negated to some extent--if not
eliminated--by the crowding out effect
(4) Remember: the LRAS curve is vertical, so from a macroeconomic
perspective, fiscal policy can shift output between the public and
private sectors, it cannot increase it.
(5) Figure 5: The Crowding Out Effect. P. 759.
vi. Changes in Taxes.
(1) With a temporary tax reduction, the effect on the economy is fairly
small.
FYI: How Fiscal Policy Might Affect Aggregate Supply, P. 760.
i.
If FP affects either the supply or the demand for labor, it can affect AS.
ii.
Supply side economists argued that the influence of tax cuts on aggregate
supply is large.
4. Using Policy to Stabilize the Economy
a.
The Case for Active Stabilization Policy is based on Alice in Wonderland.
i.
The lags are too long and
ii.
We do not have quality data soon enough.
iii. Case Study: Keynesians in the White House, P. 762.
(1) MIT Press published a book that contained the Economic Reports of
the President from 1962 and 1982.
(2) The 1962 Report is viewed as the strongest statement for Keynesian
policies.
(3) The 1982 Report, in which I was responsible for a chapter, is viewed
as the strongest rejection of the Keynesian policies.
iv. In The News: How Large is the Fiscal Policy Multipier?, P. 762.
b. The Case Against Active Stabilization Policy is based on the undisputable problems
created by lags.
i.
A recession is two quarters of negative GDP growth and it seldom lasts
more that three quarters, so you do not know you had a recession until it is
Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand
Principles of Economics, 7th Edition
N. Gregory Mankiw
Page 4
almost over.
Even when the recession is recognized, it takes awhile for Congress and the
Fed to act and then for their actions to have any effect.
iii. Because of these lags, it is impossible for the government to effectively
pursue an action counter-cyclical policy.
Automatic Stabilizers are changes in Fiscal policy that stimulate aggregate
demand when the economy goes into a recession without policymakers having to
take any deliberate action. P. 764.
i.
The tax system and
ii.
unemployment compensation.
ii.
c.
5. Conclusion
6. Summary