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CHAPTER OUTLINE
Fiscal Policy Effects
Policy Effects and
External Shocks in the
AD/AS Model
Fiscal Policy Effects in the Short Run
Fiscal Policy Effects in the Long Run
Monetary Policy Effects
Shape of the AD Curve
When the Fed Cares More about the Price Level than
Output
What Happens When There is a Zero Interest Rate
Bound?
Shocks to the System
Cost-Push Inflation
Demand-Pull Inflation
Monetary Policy since 1970
Inflation Targeting
Looking Ahead
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Fiscal Policy Effects in the Short Run
Both net taxes T (taxes minus transfer payments) and
government spending G are important fiscal policy instruments.
Earlier, we learned that the tax multiplier is smaller in absolute
value than is the government spending multiplier.
An expansionary fiscal policy (a decrease in net taxes and/or
an increase in government spending) increases output (Y).
Both result in a RIGHT shift of the AD curve.
A contractionary fiscal policy (an increase in net taxes
and/or a decrease in government spending) decreases output
(Y). Both result in a LEFT shift of the AD curve.
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Case 1:
A Right Shift of the AD Curve
When the Economy is on the
Almost Flat Part of the AS
Curve
There is an increase in output with little increase in the price level. When the
economy is producing on the nearly flat portion of the AS curve, firms are
producing well below capacity, and they will respond to an increase in demand
by increasing output much more than they increase prices.
This is the case where an expansionary fiscal policy works well.
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Case 2:
A Right Shift of the AD
Curve When the
Economy is Operating
at or near Full
Capacity
The output multiplier is close to zero. Output is initially near full capacity, and
attempts to increase it further lead to a higher price level. With a higher price
level (inflation), the Fed, to control inflation, decreases money supply (thus
increases the interest rate). There is crowding out of planned investment.
Here, an expansionary fiscal policy does not work well.
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Fiscal Policy Effects in the Long Run
The long-run AS curve is vertical. Fiscal policy will have no effect
on output (fiscal policy is useless) in this case if wages adjust
fully to match higher prices.
How fast and to what extent wages adjust to changes in
prices?
If wages are slower to adjust, the AS curve keeps an upward
slope for a long period and fiscal policy is useful.
How fast and to what extent wages adjust to changes in prices is
what economists debate and have different opinions on.
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Monetary Policy Effects
Money supply (and thus the interest rate value) that Fed
chooses is THE important monetary policy instrument.
An expansionary monetary policy (an increase in money
supply) increases output (Y), resulting in a RIGHT shift of the
AD curve.
A contractionary monetary policy (a decrease in money
supply) decreases output (Y), resulting in a LEFT shift of the AD
curve.
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Case 1:
A Shift of the AD Curve
When the Economy is on the
Almost Flat Part of the AS
Curve
There is an increase in output with little increase in the price level. When the
economy is producing on the nearly flat portion of the AS curve, firms are
producing well below capacity, and they will respond to an increase in demand
by increasing output much more than they increase prices.
This is the case where an expansionary monetary policy works well.
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Case 2:
A Shift of the AD Curve
When the Economy is
Operating at or near
Full Capacity
Output is initially close to capacity, and attempts to increase it further mostly
lead to a higher price level. With a higher price level (inflation), the Fed, to
control inflation, decreases money supply (thus raises the interest rate), and in
this case, there is almost complete crowding out of planned investment.
Here, an expansionary monetary policy does not work well.
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AD is Relatively Flat When the Fed Cares More About the
Price Level than Output
The Fed cares about (1) stable prices and (2) output/income (and
many others).
Suppose the Fed worries more about the price level than
output. In this case, when the Fed sees a price increase, it
responds with a large decrease in money supply (thereby a large
increase in the interest rate) and leads to a left shift of the AD curve.
The AD curve is relatively
flat, as the Fed is willing to
accept large changes in Y
to keep P stable.
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What Happens When There is a Zero Interest Rate Bound?
The Fed affects AD via a change in money supply, which leads to
a change in the interest rate and thereby the planned investment.
However, the interest rate cannot be below zero.
Zero Interest Rate Bound The interest rate cannot go below
zero.
Once the interest rate is zero, an increase in money supply fails
to lower the interest rate futher, which renders monetary policy to
become void (useless).
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AD Curve When Zero Interest Rate?
The AD curve becomes vertical when the interest rate has
reached zero.
The AD Curve in a Zero Interest
Rate Binding Situation.
Changes in government spending (G) and net taxes (T) still shift
the AD curve even if it is vertical. In fact, with a vertical AD curve,
fiscal policy can be used to increase output, but monetary policy
cannot.
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Cost-Push Inflation
A Negative Cost Shock
cost-push, or supply-side, inflation: Inflation caused by an increase in costs.
stagflation Occurs when output is falling at the same time that prices are
rising.
The LEFT shift of the AS curve lowers output and raises the price level. The
extent of the changes in output and the price level depend on the shape of the
AD curve.
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Demand-Pull Inflation
demand-pull inflation Inflation that is initiated by an increase in
aggregate demand.
A rise in consumer confidence—can be thought of as a “demand-side
shock.”
Instead of being triggered by a fiscal or monetary policy change, the
demand increase is triggered by something outside of the model. Any
price increase that results from a demand-side shock is also
considered demand-pull inflation.
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Inflation Targeting
inflation targeting When Central Bank chooses its money supply
(thus, interest rate values) with the aim of keeping the inflation rate
constant or within some specified band over some specified horizon.
There has been much debate about whether inflation targeting is a
good idea. It can lower fluctuations in inflation, but possibly at a cost of
larger fluctuations in output.
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REVIEW TERMS AND CONCEPTS
binding situation
cost-push, or supply-side inflation
demand-pull inflation
inflation targeting
stagflation
zero interest bound
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