Chapter 16 The Influence of Monetary Policy on Aggregate Demand
Chapter 16 The Influence of Monetary Policy on Aggregate Demand Econ 202 - 01
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Chapter 16 ~ The Influence of Monetary Policy on Aggregate Demand Introduction This chapter continues the analysis of short-run (less than 3 years), and its effects of fiscal and monetary policy which work through the shifts in aggregate demand. Fluctuations in the economy’s overall output of goods and services and its overall level of prices are due to these short-run (< 3 years) shifts of aggregate-demand and aggregate-supply. These short-run fluctuations are responsible for employment and output. This chapter focuses on the government’s tools which are used to “offset” the AD curve: Monetary Policy ~ the central bank sets the level of money supply for the economy Fiscal Policy ~ sets the level of government spending and taxation How Monetary Policy Influences Aggregate Demand 3 Reasons for the downward shift of the AD curve: Y = C + I + G + NX 1. The Wealth Effect ~ ↓ Prices → ↑ 1/P → ↑ C → ↑ demand for goods and services 2. The Interest-rate Effect ~ ↓ Price level → ↓ Money holdings → ↓ r.i.r. → ↑ I → ↑ demand for US goods and services a. NOTE: The interest-rate effect has the greatest impact and is the most important in regards to the slope of the AD curve 3. The Exchange-rate Effect ~ ↓ Price level → ↓ r.i.r. → ↑ DPFA → ↓ 1/P → ↓ E → ↑NX → ↑ US goods and services demanded, or (↑ P → ↑ r.i.r. → ↓ NCO → ↑ RER → ↓ NX) These 3 effects occur simultaneously. The wealth effect is the least important. Net exports only account for a small portion of the US economy. The interest-rate effect is the most important in regards to the downward slope of the aggregate-demand curve. This theory of interest rates helps to explain the downward slope of the aggregate-demand curve, as well as how monetary and fiscal policy can shift this curve. The Theory of Liquidity Preference ~ is John Maynard Keynes’ theory that the interest rate adjusts to bring money supply and money demand into balance. The r.i.r. (real interest rate) ~ adjusts (moves) to balance the supply and demand for money o Assume that the money supply is fixed by the Fed and does NOT depend upon the interest rate This theory explains the relationship between the nominal and real interest rates. When there is no inflation, these two interest rates move in tandem and differ only by a “constant” variable. The inflation rate is typically stable over the short run. st Money Supply ~ is the 1 piece and part of liquid preferences ~ the Fed’s policy instrument The money supply is primarily altered via the changing of the level of reserves in the banking system via the purchase and sale of government bonds in the open-market operations. Another way the Fed changes money supply is by changing the discount rate which is the interest rate at which banks can borrow from the Fed. This determines the amount of reserves that a bank will have and its ability to make loans. The Fed can change the supply of money by changing reserve requirements. The Fed can change the supply of money by changing the interest rate it pays banks to hold money on reserve. Once the Fed has made its policy decision, the quantity of money supplied is the same (fixed), and it does NOT depend upon other economic variables: The prevailing interest rate has NO effect on the fixed money supply. Money Demand ~ is the 2 piece and part of liquid preferences Liquidity ~ refers to the ease with which that asset can be converted into the economy’s medium of exchange. Money Demand ~ is the amount (quantity) of peoples’ wealth which they want to hold (holdings) in liquid form. o Money ~ is liquid but pays no interest ~ people hold (demand) more money when the r.i.r. is low o Bonds ~ pays interest; however, bonds aren’t as liquid as money Interest rate is the most relevant variable of money demand in the theory of liquidity preference, because interest rate is the opportunity cost of holding money. o ↑ r.i.r. → ↑ cost of holding money → ↓ quantity of money demanded (holdings) o ↓ r.i.r. → ↓ cost of holding money → ↑ quantity of money demanded (holdings) Variables that influence money demand: o Y ~ real income ~ determines quantity of goods and services people want to buy o P ~ price ~ only determines the number of dollars needed to buy that quantity of goods & services o r.i.r. ~ real interest rate ~ is the opportunity cost of holding money Suppose that real income (Y) increases, and other things being equal, what happens to money demand? Y ↑ → Consumption (C) ↑ → Money Demand ↑ o People sell-off bonds in order to increase money holdings for consumption Suppose the interest rate rises, but “Y” and “P” are unchanged, what happens to the money demand? r.i.r. ↑ → people will buy bonds → ↓ money supply and money demand Suppose (P) increases, but (Y) and (r.i.r.) are unchanged, what happens to the amount of money demanded? P ↑ → Money Demand ↑ (If “Y” is unchanged, people will still want to buy some level of goods and services Equilibrium in the Money Market ~ is the 3 piece and part of liquid preferences The equilibrium interest rate ~ is that point in which the quantity of money demanded exactly balances the quantity of money supplied: In other words, the interest rate adjusts to balance the supply and demand for money. If the interest rate is at any other rate, above or below the equilibrium rate, people will adjust their portfolio of assets to the level of the equilibrium interest rate. When there is a surplus of money, the r.i.r. is above the equilibrium interest rate and the quantity of money that people want to hold is less than what is supplied. A shortage of money occurs when the r.i.r. is below the equilibrium interest rate, because people want to hold more money than what is supplied. Price level determines the quantity of money demanded. As prices increase, more money is exchanged whenever a good or service is sold, people will demand more and larger quantities of money and consume less. ↑ Price → ↑ money demand → MD curve shifts to the right → ↑ r.i.r. → ↓ C → ↓ Y o The aggregate-demand curve shifts to the left ↓ Price → ↓ money demand → MD curve shifts to the left → ↓ r.i.r. → ↑ I → ↑ Y o The aggregate-demand curve shifts to the right There is a negative relationship between price level and the quantity of goods and services demanded. Changes in the quantity of goods and services demanded at any given price level shifts the aggregate demand curve. Whenever the quantity of goods and services demanded changes for any given price level, the aggregate-demand curve shifts. Monetary policy is an important variable which shifts the AD curve. (Note: In this situation, the money demand curve remained stationary allowing the r.i.r balance supply and demand) o ↑ MS → ↓ r.i.r. → ↑ demand for goods and services → AD curve shifts to the right “The money supply is the Fed’s policy instrument” which is used to move the AD curve: FOMC ~ buys and sells government bonds to either increase or decrease money supply The Fed sets a “target” interest rate via the federal funds rate ~ which accommodates the day- to-day shifts in money demand, but has two obstacles or implications: o The money supply is hard to measure with sufficient precision o The money supply fluctuates over time The monetary policy can be described either in terms of the money supply or in terms of the interest rate target FOMC buys bonds → ↑ MS → ↓ r.i.r. → ↓ fed funds rate → ↑ holdings of money (demand) FOMC sells bonds → ↓ MS → ↑ r.i.r. → ↑ fed funds rate → ↓ holdings of money (demand) If congress tries to balance the budget by cutting government spending: Y = C + I + G + NX Y (income) ↓ and AD curve shifts left from A to B The Fed needs to increase the money supply and decrease interest rates The Fed ↑ the money supply → the interest rate ↓ and AD curve shifts back from B to A A stock market boom increases household wealth: Y = C + I + G + NX Y (income) ↑ and AD curve shifts right from A to B The Fed needs to decrease the money supply by increasing interest rates ↑ interest rates → ↓ consumption and investment, AD curve shifts back from B to A If war breaks out in the Middle East which causes oil prices to sour: Y = A × F[L, K, H, N] Y (output) ↓ → SRAS curve shifts to the left and price moves (↑) from A to B The Fed needs to increase money supply and decrease interest rates Interest rates ↓ → Investment spending ↑ → Y ↑ and AD curve shifts from B to C o This shift ∆ from A → B → C and higher prices is a reflection of an accommodation policy to maintain output and employment at the cost of inflated prices. (See the prior chapter on the policy and its effect of accommodation.) A quick review and recap of the AD curve shifts in regards to money supply and money demand: The prevailing interest rate has NO effect on the fixed money supply Interest ∆’s causes movements along the curve ∆’s in Y’s aggregates and/or ∆’s in Price will shift the AD curve ∆ in Money Supply → ∆ in interest rate → ∆ in investment → AD curve shifts The Fed uses monetary policy to shift the AD curve The Fed’s policy instrument is the money supply The news often reports the Fed’s “target” interest rate which is the rate that banks charge each other for short-term loans. The Fed conducts FOMC operations by the buying and selling of bonds to ∆ the money supply o The Fed buys bonds to ↑ the money supply o The Fed sells bonds to ↓ the money supply Classical Long Run MacroEconomic Theory Short Run Aggregate Demand & Interest Rates 1. Output is determined by the supplies of capital 1. The price level is (stuck) at some level (based and labor and the available production on previously formed expectations), and in the technology for turning capital and labor into short run, is relatively unresponsive to changing output. (This is the natural level of output; ???? ). economic condition. ???? 2. For any given level of output, the interest rate 2. For any given (stuck) price level, the interest adjusts to balance the supply and demand for rate adjusts to balance the supply of and demand loanable funds. for money. 3. Given output and the interest rate, the price 3. The interest rate that balances the money level adjusts to balance the supply and demand market influences the quantity of goods and for money. Changes in the supply of money lead services demanded and thus the level of output. to proportionate changes in the price. When thinking about the long-run determinates When thinking about the short-run determinates of the interest rate, it is best to keep in mind the of the interest rate, it is best to keep in mind the loanable-funds theory, which highlights the liquidity-preference theory, which highlights the importance of an economy’s saving propensities importance of monetary policy. and investment opportunities. How Fiscal Policy Influences Aggregate Demand Fiscal Policy ~ refers to the government’s choices regarding the overall level of government purchases and taxes. Fiscal Policy ~ is the setting of the level of government spending and taxation by government policymakers. o Expansionary fiscal policy ~ ↑ Consumption (C) ↑ spending or ↓ taxes → AD curve shifts to the right o Contractionary fiscal policy ~ ↓ Consumption (C) ↓ spending or ↑ taxes → AD curve shifts to the left In the short run, fiscal policies affect the aggregate-demand curve and the quantity of goods and services demanded by changes in purchases and taxes: o Directly ~ by changes in purchases and spending o Indirectly ~ by changes in taxes which influence spending decisions by firms and households (Changes in the money supply is also an indirect spending influence). The Multiplier Effect ~ are the additional shifts in the aggregate-demand curve that result when expansionary fiscal policy increases income and thereby increases (stimulates) consumer spending and consumption. This extra consumption causes further increases in aggregate demand. Because each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar, government purchases are said to have a multiplier effect (ME) on aggregate demand. o The total impact (effect) on the quantity of goods and services demanded can be much larger than the initial impulse from higher government spending. The investment accelerator ~ is a positive feedback cycle in which higher demand leads to higher income which leads to still higher demand, in which leads a company to invest more in order to produce more for consumers and is sometimes called the investment accelerator. MPC (Marginal Propensity to Consume) ~ is the fraction of extra income that households consume rather than saves; in other words, this is a person’s willingness to spend: 0 < MPC < 1 MPC = ???????????????????? ???????????????????????? ????????????????????????????= ∆???? and then ∆C = MPC × ∆Y (∆C = MPC × ∆Spending) ???????????????????? ???????????????????????? ???????? ????????????????????????∆???? ∆Y = ∆C + ∆G ∆Y = MPC × ∆Y + ∆G MPS (Marginal Propensity to Save) = 1 – MPC I and NX don’t change because the interest rate doesn’t change ???? Then we get the equation: ∆Y = ???? –???????????? × ∆G (whereas any other rGDP variable can be used) 1 M (spending multiplier) = 1 –???????????? NOTE: M represents the infinite geometrical series which indicate the total effect(s) of an initial and large impulse of purchase(s) in an economy; and to include the shifts of the AD curve which reflect output in the economy. NOTE: There’s a difference in how these different equations are used!!! ∆C = MPC × ∆Spending ~ is used in determining amounts of consumption to spending 1 ∆Y = M × ∆G = (1 –???????????? × ∆G) ~ is used in determining demand and the shifts of the AD curve 1 Using the “Spending Multiplier” (M) = 1 –???????????? and the MPC “Marginal Propensity to Consume” If MPC = 0.8, then “M” (spending multiplier) = 1 = 1 = 5 and using: ∆Y = 1 × ∆G 1 –0.8 0.2 1 –???????????? o So, if a government purchase increased a company’s income by 100; then 5 × 100 = 500 would be the economy’s total effect on demand (Y) for goods and services within the economy. (Only if there’s NO crowding-out by ↑ interest rates). ∆C = MPC × ∆Spending (Assume here that MPC = 0.8 and there’s no crowding-out) o If MPC = 0.8 and one’s income rises $100 dollars, then one’s Consumption rises by $80 If the government increased spending by $200, what would this effect be on the AD curve? o MPC = 0.8 and then M = 5. ∆Y = 1 × ∆G and then 5 × $200 = $1,000 1 –???????????? o The AD curve would shift to the right by $1,000 o Instead, G → $40, then 5 × 40 = $200 and the AD curve shifts right by $200 (page # 11) If the government needs to shift the AD to the right by $200 because of a recession. o Again, assume MPC = 0.8 and then M = 5 1 200 o ∆Y = 1 –????????????× ∆G, then $200 = 5 × ∆G then ∆Y = 5 = $40 ↑ in government spending. (Shifting the AD curve represents ∆’s in consumption and spending). Suppose for some reason the government decreased spending by $250 billion, what would be the ∆ in consumption? o ∆C = ???????????? × ∆Y then ∆C = 0.8 × 250 = –$200 consumption 1 o ∆C = ???????????? × ∆2 then ∆C = 0.8 × 200 = –$160 consumption 1 o Total effect in loss (shift) of demand: 250 × 1 –0.8 250 × 5 = – $1,250 o The AD curve will shift to the left by – $1,250 Aggregate Demand Curve is: Y = C + I + G + NX and when ???? → 1 ↑ → ???? ↑ → C2 → ???? ↑ When th3 government increases spending by making a large purchase from a manufacturer, the AD demand curve shifts to the right by that amount which causes “Y” to increase and then consumption increases which in turn shifts “Y” once again and further to the right. If, Boeing gets 20 billion in a government contract, “Y” will increase by 20 billion, and then consumption (C) will increase by 20 and then “Y” will again increase by 20 billion. ???????? 1 ???????? is 2he ↑ in government spending ???????? → ???????? is the “multiplier effect” ~ C↑ → ???? ↑ (ME) 2 3 ???? ???????? 1 ???????? is 3he total gains from this which would be > the initial impulse of 20 billion If the spending multiplier (M) is 4: 4 × 20 = 80 million ~ is the overall total effects of demand for goods and services in the US economy Aggregate Demand Curve is: Y = C + I + G + NX and when ???? → 1X ↓ → ???? ↓ → C↓2→ ???? ↓ When 3 there is an overseas recession, the demand for US exports is reduced. If the NX is reduced by 10 billion, the AD falls by 10 billion and then Y falls by 10 billion, after which consumption falls by 10 billion which reduces Y again by another 10 billion. ???????? 1 ???????? is 2he ↓ in NX ???????? 2 ???????? is 3he “multiplier effect” ~ C↓ → ???? ↓ (M????) ???????? → ???????? is the total loss from this decrease which would be > the initial loss of 10B 1 3 If the spending multiplier (M) is 4: 4 × 10 = –40 billion ~ is the overall total effects and reduction (loss) in demand for goods and services demanded in the US economy Aggregate Demand Curve is: Y = C + I + G + NX and when ???? → 1X ↓ → ???? ↓ → C↓2→ ???? ↓ 3 Let’s now assume that the “MPC” is 0.2 which will give us a spending multiplier “M” of 1.25. What would be the value of the multiplier effect? ???????? 1 ???????? is 2he ↓ in NX (–10billion) ???????? 2 ???????? is 3he “multiplier effect” ~ C↓ → ???? ↓ (M????) ???????? → ???????? is the total loss from this decrease which would be > the initial loss of 10B 1 3 Using: M = 1 = 1 = 1.25 1 –???????????? 1 –0.2 ∆Y = M × ∆NX = 1.25 × 10 = 12.5 billion (this is the total ∆ loss due to the ME) ???????? 3 ???????? = 212.5b – –10b = –$2.5 billion NOTE: That the “value” of the ME is the difference between ???? an3 ???? (????????2→ ???????? 2, and t3e ∆’s in output before the ME was applied and after consumption was reduced further by the ME. Let’s suppose the spending multiplier (M) is 5. What then is the MPC? M = 1 then 5 = 1 which is 5 × (1 – MPC) = 1 1 –???????????? 1 –???????????? 5 – 5MPC = 1 and then –5MPC = 1 – 5 = -4 −4 -5MPC = -4 then MPC = = 0.8 −5 A bigger MPC (marginal consumption to consume) means the changes in “Y” from the changes in “G” causes the changes in consumption to be greater because of a larger response to income and thus an ???? increased multiplier: ???? –???????????? 1 1 If MPC = 0.5, then M = = = 2 1 –015 0.5 1 If MPC = 0.75, then M = = = 4 11–0.751 0.25 If MPC = 0.9, then M = = = 10 1 –0.9 0.1 On the other hand, the Crowding-Out Effect balances or counters this process. The Crowding-Out Effect ~ is the “offset” in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. o The increase in r.i.r. causes the AD curve to shift back to the left from where it was before the multiplier effect moved it originally to the right. o So, the size of the AD curve shift may be less than the initial fiscal expansion. The effect of “crowding-out: o ???????? → 1???? is th2 ↑ in government spending o ???????? → ???????? is the “crowding-out effect” ~ C↓ → ???? ↓ 2 3 ???? o ???????? → 1???? is th3 net gain from this which equals ???????? – ???????? 3 2 NOTE: The amount of the crowding-out effect will be dependent upon the spending multiplier (M). So, the amount of increases in interest will affect investments negatively. The amount of ∆ in investing (I) will be related to the size of M and the effect of the ratio between what interest rates will have towards investing. If the interest rate changes by 1% and this proportionately affects “I” by 100 (a 100:1 ratio), then investment will decrease by 100 for each incremental increase in interest of 1%. o The 1% ↑ in interest decreases investment by $100 and reduces “Y” by $100 1 o If the decrease in investment is $100 and M = 5, then ∆Y = × ∆I = 5 × 100 = $500 1 –???????????? 1 o The AD curve (Y) will shift left by $500 dollars because of: ∆Y = × ∆I 1 –???????????? Taxation: The other important instrument of fiscal policy, besides the level of government purchases, is the level of taxation. Because a tax-cut increases households’ disposable income, consumer spending will increase and the tax cut shifts the aggregate-demand curve to the right. On the other hand, a tax increase shifts the AD curve to the left. The amount of this shift is also dependent upon the multiplier and crowding-out effect. Multiplier, Crowding-Out and Perceptions: The ME ~ If ↑ G and/or ↓ Taxes o ↑ ???? →2↑ C → ↑ ???? again3→ AD curve shifts to the right o ↑ Y → ↑ Money Demand → ↑ r → ↓ I → AD curve shifts back to the left Crowding Out → ↑ r.i.r. → ↓ I → ↓ Y and ↓ Consumption and the AD curve shifts left Perceptions and Expectations o Permanent → spending will increase significantly o Temporary → spending will increase only fractionally We also saw early (top of page # 8) that if the government needs to shift the AD curve to the right by $200 because of a recession, it must increase spending by $40. Again, assume MPC = 0.8 and then M = 5 and the government wants the AD at $200 billion. 1 200 ∆Y = × ∆G, then $200 = 5 × ∆G then ∆Y = = $40b ↑ in government spending. 1 –???????????? 5 Then the AD curve shift ↑ to the right by: ∆C = MPC × ∆Y = 0.8 × 200 = $160b ($160 is the ME) o ???????? +1???????? + ????2 = 0 +3$40b + $160b = $200 billion ???? – ???? = $40b and ???? – ???? = $200b and ???? – ???? = $160b ($160 is the ME) 2 1 3 1 3 2 ???? –3???? =2200b – 40b = $160 billion and the multiplier effect (ME) If “crowding out effect” occurred and only an extra $140 of consumption occurred in the economy, then the result would be: ???? – 3 = 240 – 180 = $20b and then C.O.E = $20b o $200b – $140b – $40b = $20 billion Thus if crowding-out occurs, congress will need to increase its injection of money. Using Policy to Stabilize the Economy 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. Policy instruments help to stabilize the AD curve and its fluctuations. The tax system ~ is the most important automatic stabilizer o ↓ taxes → shifts AD to the right → ↓ unemployment Government spending ~ via unemployment insurance benefits, welfare benefits and other forms of income support helps to stimulate aggregate demand and consumption when full employment is insufficient. A strict balanced-budget rule would eliminate the automatic stabilizers inherent in our current system of taxes and government spending. If US fiscal policy increases the taxes, the Fed can “offset” the decrease in the aggregate- demand curve by: o ↑ the money supply → ↓ r.i.r. → ↑ I (investment) → ↑ Y → ↓ unemployment John Maynard Keynes stated that, “fluctuations in aggregate demand occur mostly due to waves of pessimism and optimism and used the term “animal spirits.” And these attitudes tend to be self-fulfilling. The primary argument against active monetary and fiscal policy is that these policies affect the economy with a long lag. It takes about six months for these (monetary) policy changes to show up in the economy when the Fed makes a change to the money supply or fed funds rate o The effect of these polices can last for several years The lag in fiscal policy is due to the lengthy process of a bill going through congress and being signed into law Does size matter? Multipliers (M) are bigger in closed economies than is open ones because less of the economic stimulus leaks abroad because of imports. Multipliers (M) have been traditionally bigger in rich countries than in emerging markets where investors tend to take fright more quickly and thusly pushing up interest rates. Summary and Review of Concepts from Chapter 16 In developing a theory of short-run economic fluctuations, Keynes proposed the theory of liquidity preference to explain the determinants of the interest rate. According to this theory, the interest rate adjusts to balance the supply and demand for money. An increase in the price level raises money demand and increases the interest rate that brings the money market into equilibrium. Because the interest rate represents the cost of borrowing, a higher interest rate reduces investment and; thereby, the quantity of goods and services demanded. The downward-sloping aggregate-demand curve expresses this negative relationship between the price level and the quantity demanded. Policymakers can influence aggregate demand with monetary policy. An increase in the money supply reduces the equilibrium interest rate for any given price level. Because a lower interest rate stimulates investment spending, the aggregate-demand curve shifts to the right. Conversely, a decrease in the money supply raises the equilibrium interest rate for any given price level and shifts the aggregate-demand curve to the left. Policymakers can also influence aggregate demand with fiscal policy. An increase in government purchases or a cut in taxes shifts the aggregate-demand curve to the right. A decrease in government purchases or an increase in taxes shifts the aggregate-demand curve to the left. When the government alters spending or taxes, the resulting shift in aggregate demand can be larger or smaller than the fiscal change. The multiplier effect tends to amplify the effects of fiscal policy on aggregate demand. Because monetary and fiscal policy can influence aggregate demand, the government sometimes uses these policy instruments in an attempt to stabilize the economy. Economists disagree about how active the government should be in this effort. According to advocates of active stabilization policy, changes in attitudes by households and firms shift aggregate demand: If the government does not respond, the result is undesirable and unnecessary fluctuations in output and employment. According to critics of active stabilization policy, monetary and fiscal policy work with such long lags that attempts at stabilizing the economy often end up being destabilizing. PS: Well, this concludes our semester of MacroEconomics. I expect that we will all see each other one more time when we take our final test for this class. I wish you good luck with your studies and a wonderful time off during summer vacation!!