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Econ Notes

This document discusses monetary and fiscal policy tools used by the Federal Reserve and government to stabilize the economy. It covers topics such as: - How the Fed can expand, contract, or leave the money supply unchanged to counter shifts in aggregate demand. - How lower prices lead to wealth, interest rate, and exchange rate effects that cause the aggregate demand curve to slope downward. - How the Fed uses open market operations and other tools to target interest rates and influence the money supply. - How fiscal policy tools like taxes and government spending can be used to shift aggregate demand, but are subject to multiplier and crowding out effects. - Automatic stabilizers and arguments for and against government taking an active

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53 views

Econ Notes

This document discusses monetary and fiscal policy tools used by the Federal Reserve and government to stabilize the economy. It covers topics such as: - How the Fed can expand, contract, or leave the money supply unchanged to counter shifts in aggregate demand. - How lower prices lead to wealth, interest rate, and exchange rate effects that cause the aggregate demand curve to slope downward. - How the Fed uses open market operations and other tools to target interest rates and influence the money supply. - How fiscal policy tools like taxes and government spending can be used to shift aggregate demand, but are subject to multiplier and crowding out effects. - Automatic stabilizers and arguments for and against government taking an active

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peatr
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© © All Rights Reserved
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Notes 473-493

Monetary and Fiscal Policy


Three considerations by the Fed:
Expand money supply, contract money supply, or leave it alone?
Policymakers will use monetary and fiscal policy to counter short-run shifts in AD, in
order to keep the economy stable and prevent painful adjustments.
Why does AD curve slope downward (previous chapter)?
Wealth effect: lower prices raise real value of household money holdings,
stimulates consumer spending
Interest-rate effect: lower prices reduce the amount of money people hold, so
money supply increases and interest rate falls, stimulating investment spending.
Exchange-rate effect: lower prices reduce interest rate, so investors move money
overseas for higher returns. Real value of domestic currency falls in the market for
foreign-currency exchange, and real exchange rate falls, so domestic goods become less
expensive than foreign goods, which spurs demand.
Summary: Lower prices wealth effect interestrate effect exchange-rate effect
Note: the three effects occur simultaneously, move q along the AD curve as
prices fall.
Wealth effect is the least significant (because people dont hold much money)
Exchange-rate is also small, since imports/exports are a small part of US GDP.
Interest-rate effect
Theory of Liquidity Preference
Keynes: General Theory of Employment, Interest and Money
Interest rate adjusts to balance supply and demand for money.
Nominal and Real interest rates: loans are for more than real interest
because of expected inflation.
Monetary Policy and AD
Fed tools: open-market, reserve ratio, discount rate all alter the money
supply in the economy
(i.e. money supply does not depend on the interest rate, so it is
vertical)
Money is the most liquid asset.
Interest rate is the opportunity cost of holding money (hold cash, lose interest)

Decrease in interest rate reduces cost of holding money, curve slopes downward.
Interest rate is on the y-axis, quantity of money on the x-axis (figure 1, p. 476).
At the equilibrium interest rate, $ demand = $ supply.
Figure 2, p. 479, increase in price level leads to holding more money, so higher
interest rate, which leads to increased money demanded (higher quantity of money
demanded for every interest rate). Interest rate must rise to slide demand back along the
new curve to equilibrium, since money supply is unchanged.
Summary:
Higher price level raises money demand.
higher interest rate
reduced quantity of goods and services demanded (which is shown in
the downward slope of AD)
Figure 3: Fed initiates open-market operations, buying bonds to increase the
money supply.
Shifts the vertical MS curve right, which lowers the interest rate.
Lower interest rate increases demand (shifts right).
Why does the Fed target interest rates as their main policy objective? Because they are
accommodating shifts in money demand, and money supply is hard to measure.
So monetary policy can be described in terms of money supply or interest rate.
Lower Fed funds rate to 5% means buy government bonds to increase the money
supply and lower the interest rate.
Expansionary Policy: MS, r
Contractionary Policy: r, MS
Stock Market
Stock boom increases household wealth (C) and stimulates I for businesses. Expands
AD.
Fed response should be MS, r, to offset expansionary effects of higher stock
prices.
When the Fed raises r, reduced profits shifts demand left, and stock prices us. fall.
Fiscal Policy and AD
Taxes shift AD indirectly by changing household spending, while government spending
shifts AD directly.
Multiplier Effect: shifts in AD from government spending may be larger than the
expenditure.

Crowding out effect: shifts in AD from government spending may be smaller than the
expenditure.
Multiplier Effect
G increases consumer spending, which increases profits, which restimulate consumer
spending. Investment accelerator: positive feedback from demand to investment.
MPC: Marginal Propensity to Consume
Fraction of extra income a household consumes rather than saves.
Suppose government spends $20 billion, and MPC is 3/4.
means spend .75 and save .25. So .75 * 20 billion = 15.
Next amount is .75 *.75*20 billion.
Total changes is (1+MPC+MPC2+MPC3+)*20 billion
Multiplier is 1/(1-MPC) = 4
So $20 billion generates $80 billion in demand.
Multiplier applies to increased spending on any component of GDP.
Crowding-Out Effect
Increase in demand causes interest rate increase, which reduces investment spending and
pressures demand downward.
Increase in income causes households to hold more money, as they plan to make
purchases, which increases demand for money. (Fed has not changed money supply, so
vertical supply curve is fixed). MD shifts right, so r1 rises to r2 (figure 5), and quantity
of goods and services is reduced. Demand for residential and business investment
declines (is crowded out by money demand).
Government increases spending, multiplier increases demand further, crowding out
diminishes the effectcould even make it less than the amount spent)
Tax changes are also affected by the multiplier and crowding out, in the same way. Also,
household perceptions play a role. People will more likely bank the savings if they think
the tax cut is temporary.
George Bushs 1992 tax cut: Reduced withholding, but taxes were still due in 1993;
people did not spend more, and he was not re-elected.
Stabilization Policy
Employment Act of 1946: it is the continuing policy and responsibility of the federal
government topromote full employment and production.

Government has to avoid being a cause of economic fluctuations.


Government has to respond to changes in the private economy to stabilize AD.
Passed not long after Keynes book was published.
Keynes argument: irrational waves of pessimism and optimism (animal spirits) cause
AD to fluctuate.
Kennedys 1964 tax cut was to stimulate demand and also shift AS to the right. Double
increase led to expanded production and healthy growth.
G.W. Bush did the same in 2001.
Argument against stabilization: lag time of up to 6 months makes effects delayed, and
effects can last for several years. Fed often reacts too late, and becomes a cause of
fluctuation rather than a cure.
Automatic Stabilizers
Tax system. During a recession, lower income/revenue means lower taxes, stimulates
demand.
Government spending. Recession means more unemployment benefits, more welfare,
etc.
A reason to oppose balanced budget amendment.

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