Download Monetary and Fiscal Policy Interact

Monetary and Fiscal Policy
Interact
Unit 5 Lesson 2
Activity 45
By John Morton
Advanced Placement Economics Teacher Resource Manual. National Council
on Economic Education, New York, N.Y
Objectives
• Practice analytical skills with AD and
SRAS model and the money market.
• Analyze the effects of combined monetary
and fiscal policies on the loanable funds
market.
Introduction
• This lesson continues an examination of
the interaction between monetary and
fiscal policy in the short-run.
• It examines the impact of monetary and
fiscal policy on output, the price level,
unemployment, interest rates and
investment.
• Your success on the AP Exam depends on
your ability to explain why economic
variables are affected.
• Activity 45 provides you with an
opportunity to work through the short-run
effects of monetary and fiscal policy on
important macroeconomic variables.
• You will continue to use the loanable funds
market and the money market in this
activity. (The following slides are not on
your activity sheet.)
The Effects of Policy Changes in Multiple Markets
Loanable Funds Market
AD and AS
Interest
Rate
PL
Interest
Rate
SRAS
p
Money Market
MS
S
i
MD
Y
AD
GDPR
D
I
Loanable
Funds
Money
• Suppose that, in response to the economic situation, the
federal government decides to increase its spending
without increasing taxes and the Fed keeps the money
supply constant. There is no Barro-Ricardo effect.
• Explain what would happen in the three markets shown
above.
Loanable Funds Market
AD and AS
Interest
Rate
PL
Money Market
Interest
Rate
SRAS
MS
S
i1
p1
p
i
D1
AD1
Y Y1
AD
GDPR
MD1
MD
D
I
I1
Loanable
Funds
• The AD curve should shift to the right.
• Increase the demand for loanable funds by
shifting the curve to the right.
• The demand for money should also shift to the
right.
• The interest rates in the money market and
loanable funds should be equal.
Money
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
SRAS
MS
S
i1
p1
p
i
D1
AD1
Y Y1
AD
GDPR
MD1
MD
D
I
I1
Loanable
Funds
Money
2. What happened to each of the following
variables and why:
A. Output (real GDP):
Increased. AD increased because of the
increase in government spending
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
SRAS
MS
S
i1
p1
p
i
D1
AD1
Y Y1
AD
GDPR
MD1
MD
D
I
I1
Loanable
Funds
Money
B. Employment:
Increased. AD increased because of the
increase in government spending
C. Price level:
Increased. AD increased because of the
increase in government spending
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
SRAS
MS
S
i1
p1
p
i
D1
AD1
Y Y1
AD
GDPR
MD1
MD
D
I
I1
Loanable
Funds
Money
D. Interest rates:
Increased. With the money supply held
constant, the demand for money increased or
the demand for loanable funds increased.
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
SRAS
MS
S
i1
p1
p
i
D1
AD1
Y Y1
AD
GDPR
MD1
MD
D
I
I1
Loanable
Funds
E. Investment:
Decreased because of the increase in
interest rates
Money
Loanable Funds Market
AD and AS
Interest
Rate
Interest
Rate
SRAS
MS
S
i1
p1
p
i
D1
AD1
Y Y1
•
Money Market
AD
GDPR
MD1
MD
D
I
I1
Loanable
Funds
Was there crowding-out present in the
above graphs?
• In the Loanable Funds Market graph, the
government’s demand for funds increased
the interest rate.
Money
4. Answer the following questions:
A. What could the Fed have done to prevent
crowding-out?
The Fed could use expansionary monetary
policy; thus the government’s demand for
funds would not result in an increase in
interest rates.
A. Are there certain conditions when the Fed
should or should not prevent crowding-out?
If the economy were experiencing a recession,
the Fed would want to prevent crowding-out, but
if the economy were at or near full employment
and government spending increased, the Fed
might not want to prevent crowding-out.
Graphing Monetary and Fiscal Policy
Interactions
• Illustrate the short-run effects for each monetary
and fiscal policy combination using AD and AS
curves, the money market and the loanable
funds market.
• Once again, assume that there are no changes
in the foreign sector.
• Circle the appropriate symbols (↑ for increase, ↓
for decrease, and ? for uncertain), and explain
the effect of the policies on real GDP, the price
level, unemployment, interest rates and
investment.
1. The unemployment rate is 10%, and the
CPI is increasing at a 2% rate. The
federal government cuts personal
income taxes and increase its spending.
The Fed buys bonds on the open market.
PL
Loanable Funds Market
AD and AS
Interest
Rate
Interest
Rate
SRAS
p
Money Market
MS
S
i
Y
AD
GDPR
MD
D
I
Loanable
Funds
Money
Expansionary Monetary and Fiscal Policy
PL
Money Market
AD and AS
Interest
Rate
Interest
Rate
SRAS
p1
S
S1
i1
i
p
AD1
Y Y1
AD
GDPR
(A) Real GDP:
MS MS1
D1
D
MD
Loanable
Funds
I
?
Explain
Both policies are expansionary: C, G & I will
all increase.
MD1
Expansionary Monetary and Fiscal Policy
PL
Money Market
AD and AS
Interest
Rate
Interest
Rate
SRAS
p1
S
S1
i1
i
p
AD1
Y Y1
MS MS1
AD
GDPR
(B) The Price Level:
D1
MD
D
I
Loanable
Funds
?
Explain
The increase in AD will increase the PL
MD1
Expansionary Monetary and Fiscal Policy
PL
Money Market
AD and AS
Interest
Rate
Interest
Rate
SRAS
p1
S
S1
i1
i
p
AD1
Y Y1
MS MS1
AD
GDPR
(C) Unemployment:
D1
MD
D
I
Loanable
Funds
?
Explain
The increase in AD will increase employment
and output.
MD1
Expansionary Monetary and Fiscal Policy
PL
Money Market
AD and AS
Interest
Rate
Interest
Rate
SRAS
p1
S
S1
i1
i
p
AD1
Y Y1
MS MS1
AD
GDPR
(D) Interest Rates:
D1
MD
D
I
MD1
Loanable
Funds
?
Explain
Fiscal policy would result in an increase in interest rates;
monetary policy would result in lower interest rates. The
net effect depends on the relative strength of the two
policies. The graph here shows a slight increase in interest
rates; the effect on interest rates is indeterminate.
Expansionary Monetary and Fiscal Policy
PL
Money Market
AD and AS
Interest
Rate
Interest
Rate
SRAS
p1
S
S1
i1
i
p
AD1
Y Y1
AD
GDPR
(E) Investment:
MS MS1
D1
MD
D
I
Loanable
Funds
?
Explain
Because we can’t tell what happens to
interest rates, we can’t say what happens
to investment because of changes in the
interest rate.
MD1
2. The unemployment rate is 6%, and the CPI is
increasing at a 9% rate. The federal
government raises personal income taxes and
cuts spending. The Federal Reserve sells
bonds on the open market.
PL
Loanable Funds Market
AD and AS
Interest
Rate
Interest
Rate
SRAS
p
Money Market
MS
S
i
MD
AD
Y
GDPR
D
I
Loanable
Funds
Money
Contractionary Monetary and Fiscal Policy
PL
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
S1
SRAS
p
MS1 MS
S
i
p1
AD
AD1
Y1 Y
GDPR
(A) Real GDP:
MD
D
D1
I Loanable
Funds
?
MD1
Money
Explain
Decreased AD should lower GDP somewhat.
AD decreases because of contractionary
monetary and fiscal policy.
Contractionary Monetary and Fiscal Policy
PL
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
S1
SRAS
p
MS1 MS
S
i
p1
AD
AD1
Y1 Y
GDPR
(B) The Price Level:
MD
D
D1
I Loanable
Funds
?
MD1
Money
Explain
The decrease in AD should result in a lower PL
Contractionary Monetary and Fiscal Policy
PL
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
S1
SRAS
p
MS1 MS
S
i
p1
AD
AD1
Y1 Y
GDPR
(C) Unemployment:
MD
D
D1
I Loanable
Funds
?
MD1
Money
Explain
Lower output decreases employment on the
SRAS curve.
Contractionary Monetary and Fiscal Policy
PL
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
S1
SRAS
p
MS1 MS
S
i
p1
AD
AD1
Y1 Y
GDPR
(D) Interest rates:
MD
D
D1
I Loanable
Funds
?
MD1
Money
Explain
The Fed decreases the money supply, which should result in an increase in
interest rates. The increase in taxes and decrease in government
spending result in a decrease in interest rates since the demand for
loanable funds by the government should decrease. The demand for
money decrease because of the decrease I real GDP. Interest rates will be
higher if the decrease in demand is less than the decrease in supply in the
money market. The interest rate effect is indeterminate.
Contractionary Monetary and Fiscal Policy
PL
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
S1
SRAS
p
MS1 MS
S
i
p1
AD
AD1
Y1 Y
GDPR
(E) Investment:
MD
D
D1
I Loanable
Funds
?
MD1
Money
Explain
If interest rates are higher; there would be a decrease in the
level of investment. If interest rates are lower, there would
be an increase.
3. The unemployment rate is 6%, and the CPI is
increasing at a 5% rate. The federal
government cuts personal income taxes and
maintains current spending. The Fed sells
bonds on the open market.
PL
Loanable Funds Market
AD and AS
Interest
Rate
S
Money Market
Interest
Rate
MS
SRAS
p
i
AD
Y
GDPR
D
I
Loanable
Funds
MD
Money
Contractionary Monetary Policy and Expansionary Fiscal
Policy
PL
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
S1
SRAS
p
i1
MS1 MS
S
i
AD
Y
GDPR
(A) Real GDP:
D
D1
MD
Loanable
Funds
I
?
Money
Explain
The combined effect on AD is impossible to
predict. The fiscal policy is expansionary,
and the monetary policy is contractionary.
Contractionary Monetary Policy and Expansionary Fiscal
Policy
PL
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
S1
SRAS
p
i1
MS1 MS
S
i
AD
Y
GDPR
(B) Price Level:
D
D1
MD
Loanable
Funds
I
?
Explain
The impact on the price level is impossible to
predict given the contradicting monetary
and fiscal policies.
Money
Contractionary Monetary Policy and Expansionary Fiscal
Policy
PL
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
S1
SRAS
p
i1
MS1 MS
S
i
AD
Y
GDPR
(C) Unemployment:
D
I
D1
MD
Loanable
Funds
?
Explain
The impact on output and, hence,
employment is impossible to predict given
the contradicting monetary and fiscal
policies.
Money
Contractionary Monetary Policy and Expansionary Fiscal
Policy
PL
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
S1
SRAS
p
i1
MS1 MS
S
i
AD
Y
GDPR
(D) Interest rates:
D
I
D1
MD
Loanable
Funds
?
Money
Explain
Interest rates will rise because of the increased
demand for and reduced supply of loanable
funds.
Contractionary Monetary Policy and Expansionary Fiscal
Policy
PL
Loanable Funds Market
AD and AS
Interest
Rate
Money Market
Interest
Rate
S1
SRAS
p
i1
MS1 MS
S
i
AD
Y
GDPR
(E) Investment:
D
I
D1
MD
Loanable
Funds
?
Money
Explain
The increase in interest rates will tend to
decrease investments.