Chapter 21-22 Notes
Chapter 21-22 Notes Econ201
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Date Created: 05/15/16
Chapter 21: The Influence of Monetary and Fiscal Policy on Aggregate Demand How Monetary Policy Influences AD Recall, AD slopes downward bc of wealth effect, interest rate effect, and exchange rate effect . 3 effects occur simultaneously to increase quantity of goods and services demanded when price level falls and to decrease when price level rises wealth effect is least important of the three exchange rate isn’t large for U.S because imports and exports only represent a small fraction of U.S GDP(more important for smaller countries). For U.S most important reason is the interest rate effect. Theory of Liquidity Preference Nominal and real interest rates differ by a constant When nominal rises/falls, the real interest rate people expect to earn rises or falls as well. This theory helps explain downward slope of AD curve and how monetary and fiscal policy can shift this curve. Money Supply Controlled by Fed Reserve who alters by changing quantity of reserves through purchase and sale of govt bond in open market operations. Buys govt bonds-dollars are deposited in banks and added to bank reserves Sells govt bonds-dollars are withdrawn and bank reserves fall. Fed can change how much they lend to banks through the discount rate. Discount rate-interest rate where banks can borrow reserves from Fed Decrease in discount rate, encourages more bank borrowing, increases bank reserves and money supply. Increase in discount rate, discourages bank borrowing, decreases bank reserves, and money supply. Fed can also alter money supply by changing reserve requirement and changing interest rate it pays bank on reserves they are holding Money Demand Money is the most liquid asset An increase in the interest rate raises the cost of holding money and reduces quantity of money demanded. A decrease in the interest rate reduces the cost of holding money and raises the quantity demanded Money demand curve slopes downward Equilibrium in the Money Market Quantity of money demanded balances quantity of money supplied. If interest rate is above equilibrium level, quantity of money that ppl want to hold is less than quantity of money Fed has supplied. If interest rates are below equilibrium, quantity of money ppl want to hold is greater than quantity of money that Fed has supplied. The Downward Slope of the AD Curve Output is determined by supplies of capital and labor and available production technology for turning capital/labor into output.( natural level of output). For any given level of output, interest rate adjusts to balance supply and demand for loanable funds Price level adjusts to balance the supply and demand for money. Changes in supply of money lead to proportionate changes in price level. In the short run, overall price level cannot move to balance supply of and demand for money. As AD fluctuates, economy’s output of goods and services moves from level determined by factor supplies and technology. Higher price level increases the quantity of money demanded for any given interest rate, money demanded curve will shift right At a higher interest rate, cost of borrowing and return to saving are greater, investment falls. Overall, a higher price level raises money demand, higher money leads to higher interest rate, higher interest rate reduces quantity of goods/services demanded . Lower price level reduces money demand, lower interest rate, increases quantity of goods/services. Changes in Money Supply When Fed increases money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any price level. AD shifts right When Fed contracts money supply, it raises the interest rate and reduces quantity of goods/services demanded for any given price level, AD shifts left. Role of Interest-Rate Targets in Fed Policy Federal Funds Rate-interest rate banks charge one another for short term loans Monetary policy can be described in terms of money supply or in terms of the interest rate. To lower Fed Funds Rate, bond traders buy govt bonds, money supply increases, lowers equilibrium interest rate To increase Fed Funds Rate, bond traders sell govt bonds, money supply decreases, equilibrium interest rate increases How Fiscal Policy Influences Aggregate Demand Refers to govet choices regarding level of govt purchases and taxes In the short run, primary effect of fiscal policy is on aggregate demand for goods/services Changes in Govt Purchases When policy makers change money supply or level of taxes, AD curve shifts indirectly by influencing spending decisions of firms/households. When govt alters its own purchases of goods/services, it shifts AD directly. Multiplier effect-suggest shift in AD could be larger Crowding out effect-suggest shift in AD could be smaller Multiplier Effect Dollar spent by govt can raise AD for goods/services by more than a dollar Consumer spending rises, higher profits, higher income, higher demand Positive feedback from demand is called investment accelerator Multiplier =1/(1-MPC) Applies to any event that alters spending on any component of GDP Shows how economy can amplify impact of changes in spending Crowding Out Effect Reduction in AD results when fiscal expansion raises the interest rate Money Demand curve shifts to the right, interest rate rises Increase in interest rate, reduces quantity of goods and services demanded. As increase in govt purchases increases demand for goods/services, it may also crowd out investment, forces AD to drop back Changes in Taxes Tax cut shifts AD to the right (Multiplier effect) Tax increase shifts AD to left and depresses consumer spending (Crowding out effect) If tax is permanent- seen as increasing spending by a lot If tax is temporary- increase spending by a small amount Automatic Stabilizers Changes in fiscal policy that stimulate AD when economy goes into recession w/o policy makers having to take deliberate action Most important is the tax system When econ goes into recession, amount of taxes collected falls Income tax depends on household incomes, payroll tax depends on workers earnings, corporate income tax depends on firms profits Govt spending also acts as an automatic stabilizer When economy goes into recession more ppl apply for unemployment insurance benefits, welfare benefits, other forms of income support, AD is stimulated Chapter 22: Short Run Trade-Off between Inflation and Unemployment The Phillips Curve Short run relationship between inflation and unemployment Illustrates a negative association between inflation rate and unemployment rate in AD curve and move economy along short run AS curve Increase in AD leads to larger output of goods/services and higher price level, greater employment, low rate of unemployment Higher price level , higher rate of inflation Long Run Phillips Curve According to Freidman and Phelps, no trade off between inflation and unemployment in long run. Growth in money supply determines inflation rate, unemployment gravitates toward the natural rate LRPC is vertical Theory Expected inflation: measures how much ppl expect overall price level to change . Determines position of SRAS bc expected price level affects nominal wages. In the short run- monetary changes lead to unexpected fluctuations in output, prices, inflation and unemployment In the long run people can come to expect whatever inflation rate chooses to produce and nominal wages will adjust to keep pace with inflation/ Unemployment returns to its natural rate in the long run Short run Phillips Curve Unemployment rate=Natural rate of unemployment –a(Actual inflation-Expected inflation) In the short run, expected inflation is given, higher actual inflation is linked with lower unemployment NO STABLE SRPC When expected inflation changes, SRPC shifts Shifts in Phillips Curve: Supply Shocks Event that directly affects firms costs of production and prices they charge Example: oil price increase raises cost of producing gasoline, heating oil, reduces quantity of goods supplied at any given price level. Combo of falling output(stagnation) and rising prices(inflation) is sometimes called stagflation Cost of Reducing Inflation Disinflation-reduction in rate of inflation Sacrifice Ratio Contractionary monetary supply, AD falls, unemployment rises Over time, people realize prices are rising more slowly, expected inflation falls, SRPC shifts downward, unemployment returns back to natural rate Sacrifice ratio:number of percentage points of annual output lost in process of reducing inflation by 1 percentage point
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