Transcript Mankiw: Brief Principles of Macroeconomics, Second Edition

Mankiw: Brief Principles of
Macroeconomics, Second Edition
(Harcourt, 2001)
Ch. 15: The Influence of Monetary
and Fiscal Policy on Aggregate
Demand
Monetary and Fiscal Policies
• The government has the ability to shift AD
through monetary and fiscal policies.
• Monetary policy is established by the Federal
Open Market Committee of the Federal Reserve
System.
– Increasing/decreasing money supply.
• Fiscal policy is established by the Congress and
the President.
– Changing government purchases.
– Changing taxes and transfers.
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The Importance of Interest Rates
• For the US economy the interest rate effect on
the aggregate demand is more significant than
the wealth effect and exchange rate effect.
– Money wealth is a very small percentage of total
wealth. Price level changes will not affect the total
wealth that much.
– Exports and imports comprise about a quarter of the
GDP. Furthermore, many imports are priced in
USD, so changes in exchange rates do not affect US
demand for imports.
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The Importance of Interest Rates
• Any price level increase translates into an
increase in interest rates and a consequent
drop of investment expenditures.
• Lower investment expenditures decrease the
aggregate demand showing the downward
slope in the P-Y plane.
• How does price level increase result in an
increase of the interest rate?
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Which Interest Rate?
• Investment decisions respond to real interest
rate.
• Equilibrium in the monetary sector determines
the nominal interest rate.
• For simplicity, let us assume that in the short run
expected rate of inflation remains unchanged.
• Therefore, real and nominal interest rates will
move in the same direction.
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Equilibrium in the Monetary Sector
• The monetary sector will reach equilibrium
when the supply of money is exactly equal
to the demand for money.
• When the supply is matched with demand,
the equilibrium interest rate is reached.
• The interest rate determines how much
people want to keep liquidity (money) when
the price level and real income are kept
constant.
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Money Supply
• The money supply is controlled by the Fed.
• The Fed (central bank) can change the money
supply using three different tools.
– Open market operations.
– Discount rate: the interest rate Fed charges to the
banks when they borrow from the Fed.
– Reserve requirements: the percentage of deposits
banks have to keep.
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Open Market Operations
• Buying US securities increases the money
supply.
• Selling US securities decreases the money
supply.
• This is the tool the Fed uses all the time.
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Discount Rate
• Lowering the discount rate increases the
money supply.
• Raising the discount rate decreases the
money supply.
• The Fed uses this tool sparingly.
• Usually changes in the discount rate follow
what happens in the market interest rates
rather than the other way around.
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Reserve Requirements
• Lowering the reserve ratio increases the
money supply.
• Raising the reserve ratio decreases the
money supply.
• This is too powerful to use indiscriminately.
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Money Supply
• Fed actions affect the reserves of the banks.
• When the reserves of the banks increase, the
banks give loans and create deposits.
• When the Fed buys US securities, the seller
deposits the check with her bank.
• The bank has that amount in its reserves with the
Fed.
• Since only a portion of the deposit need to be
kept at the Fed, the bank can loan the rest.
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Money Supply
• Every time the bank loans money, it creates
a checking account for the borrower.
• As the borrower spends from his checking
account, the receivers of these checks
deposit them in their banks.
• These banks now can increase their loans.
• When the Fed buys $10 million worth of
securities, because of multiple deposit
creation, money supply increases much
more than $10 million.
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Money Supply
• The Fed determines how much money supply it
wants regardless of the interest rate.
• The main concern of the Fed, these days, is the
expected inflation.
• If the Fed thinks inflation may rise in the future,
it lowers the money supply.
• If the Fed thinks the economy may slow too
much in the future, it increases the money
supply.
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Money Demand
• The demand for money is the amount of
liquid assets the society wishes to hold.
• The amount of cash and checking account
balances comprise the money demand.
• Liquidity preference is the term used by
Keynes for the demand for money.
• The amount of money people want to hold
will respond to real income, price level and
interest rate.
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Money Demand
• Higher real income means more purchases; so
people will have higher checking balances.
– Y up => Md up.
• Higher price level means people will have to pay
more for the same purchases; they will keep
higher checking balances.
– P up => Md up.
• Higher interest rates mean people can earn a
higher return by keeping funds in savings
accounts as opposed to checking accounts.
– I up => Md down.
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Money Demand
i
Real income increase
Price level increase
M
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Equilibrium in the Money Sector
i
Ms
i*
Md
M
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Equilibrium in the Money Sector
i
Ms
i1
i*
i2
Md
At i1, there is an
excess supply of
money. People lower
their money holdings
by buying bonds.
Bond prices go up,
which means interest
rates go down.
What happens at i2?
M
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Why Do Bond Prices and Interest
Rates Relate Inversely?
• A bond pays a definite interest payment per
year until maturity; at maturity it pays the
principal.
• A bond can be bought and sold at different
prices depending on supply and demand.
• If the bond is sold for a high price then the
interest payments are a small portion of the
purchase price; the return for the purchaser (the
interest rate she receives) is lower.
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Connection of Monetary Sector
Equilibrium and Aggregate Demand
• Money demand curve shows liquidity
preference at each and every level of interest
rates keeping real income and price level
constant.
• At a given money supply, the interest rate is
determined.
• When Md shifts right because of an increase in
price level, the equilibrium interest rate rises
because people sell their bonds.
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Connection of Monetary Sector
Equilibrium and Aggregate Demand
• Higher interest rate discourages investment
spending (I) in C+I+G+NX.
• Aggregate demand is now a lower figure.
• Ignoring the effect of price level rise on
wealth and real exchange rates, the two
points on the AD can be identified as two
different interest rates.
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Connection of Monetary Sector
Equilibrium and Aggregate Demand
i
P
6%
Md at P=150
Y=3000
150
4%
100
Ms
6%
4%
Md at P=100
Y=3000
M
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3000 Y
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Long-Run vs. Short-Run
1. Labor, capital and
1. The price level is
technology determine
sticky in the shortthe output (GDP).
run.
2. The loanable funds
2. Given the price level,
market determines
interest rate adjusts
the interest rate.
to balance supply and
demand for money.
3. Price level is
determined by supply 3. Aggregate demand
and demand for
determines the
money.
output.
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Increasing Ms Shifts AD Right
i
Ms1
P
Ms2
7%
P
4%
AD2
Md
AD1
Y1
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Y2
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Interest Rate or Money Supply?
• Using the money supply-money demand
diagram it is easy to see that to increase the
interest rate the Fed has to lower the money
supply and to decrease the interest rate the
Fed has to increase the money supply.
• Recently, the Fed has been announcing
interest rate targets instead of money supply
targets.
• The interest rate the Fed targets is the
federal funds rate.
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Why Does the Fed Rein-in a Stock
Market Boom?
• Imagine the economy operating at full employment.
• Stock market experiences huge gains.
• It will stimulate consumption expenditures because
of wealth effect.
• High prices of shares make it easier for firms to
raise funds cheaply; investment increases.
• Both C and I rise: AD shifts out, fueling inflation
fears.
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How Does the Fed Rein-in a Stock
Market Boom?
• To curb the outward shift of the AD curve, the
Fed would initiate an increase in the interest
rates.
• Open market sales reduce the money supply.
• Higher interest rates make bonds more attractive.
• Higher interest rates reduce investments and
future profits.
• Stock prices fall.
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Fiscal Policy
• Fiscal policy is decisions to change the budget
of the government.
– Changes in government purchases.
– Changes in tax laws.
– Changes in transfer payments.
• Increases in government purchases raise G and
shift AD to the right.
• Increases in taxes lower C or I and shift AD to
the left.
• Increases in transfer payments increase C and
shift AD to the right.
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How Much Does the AD shift?
• If government increases military spending
by $10 billion ceteris paribus, how much
does Y change?
• The multiplier effect makes the AD shift
more than $10 billion.
• The crowding-out effect makes the AD shift
less than $10 billion.
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The Multiplier Effect
• When the government spends an extra $10
billion on military, the corporations that sell the
equipment now pay an extra $10 billion to their
stockholders, employees and suppliers.
• The extra income earned by these people gets
mostly spent and partially saved.
• The portion spent becomes incomes for others
which in turn is partially saved and spent.
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The Multiplier Effect
• If, on average, people spend a constant
proportion of their additional income, then
we can calculate the full multiplier effect.
• The portion of the additional dollar income
spent on consumption is called marginal
propensity to consume (MPC).
• Because MPC is less than one, income
created in each successive round becomes
smaller until it gets close to zero.
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The Multiplier Effect
Suppose Marginal Propensity to Consume is .9 or 90%.
Extra government spending
10
First round consumption spending
10(.9)
Second round consumption spending 10(.9)(.9)
Third round consumption spending
10(.9)(.9)(.9)
Fourth round consumption spending 10(.9)(.9)(.9)(.9)
…..
Total of the rounds:
10[1+(.9)+(.9)^2+(.9)^3+(.9)^4+…+(.9)^n]
10[multiplier]
10[1/(1-.9)]
10(10)=100
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The Multiplier Effect
P
AD3
AD2
AD1
1000 1010
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1100
Y
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Examples of the Multiplier Effect
• Suppose the government increases income
taxes by $50 billion.
• The initial change on consumption will be
.9(50)=$45 billion. Why?
• AD will shift to the left.
• The multiplier effect will be a shift of
$45[1/(1-.9)] or $45(1/.1) or $45(10) or
$450.
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Examples of the Multiplier Effect
•
•
•
•
•
•
Investments increase by $20 billion.
The multiplier effect will be $20[1/(1-MPC)].
AD will shift to the right.
Net exports decline by $30 billion.
AD will shift to the left by $30[1/(1-MPC)].
These examples are autonomous expenditures;
they have nothing to do with fiscal policy.
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The Crowding-Out Effect
• A rise in government expenditures shifts
AD to the right and increases Y.
• Higher GDP increases interest rates and
reduces investments.
• Aggregate Demand (C+I+G+NX) becomes
lower than the level reached with the
multiplier.
• The higher interest rates crowded out some
of the investments.
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The Crowding-Out Effect
P
i
AD2
Ms
AD3
P1
i2
i1
AD1
Y1
Y3
Md
Md
Y2 Y
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M
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Multiplier and Crowding-Out
• Suppose a government spending increase of
$10 billion raises the GDP by $50 billion.
• If there is no crowding-out, what is the
value of MPC?
5 = 1/(1-MPC)
ΔY = mΔG
1- MPC = 1/5
50 = m10
- MPC = - 0.8
m = 50/10
MPC = 0.8
m=5
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Multiplier and Crowding-Out
• Suppose there were crowding-out and yet
the $10 billion increase in G still raised the
GDP by $50 billion. Would the MPC be
larger or smaller than 0.8?
Crowding-out is the drop of investment spending
because of an increase in interest rates as a result of G
increase. As I falls, so does AD and GDP. If GDP
rose by $50 billion, then the multiplier effect must have
been larger than 5. That implies that MPC must have
been larger than .8.
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Effects of Tax Cuts
• A tax cut will increase consumption.
• Increased consumption will have multiplier
effect.
• Higher income generated will have crowdingout effect.
• A temporary tax cut will not affect consumption
much because households know they have to
pay the tax in the future.
• A permanent tax cut will have the expected
effects.
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Supply Side Economics
• Can the government fiscal policies shift the AS
curve to the right?
– Lowering marginal tax rates may stimulate desire to
work, increasing supply of labor.
– Government spending on physical or human capital
will increase the size of the economy in the long
run.
• Increases in regulations, licensing will raise the
cost of production and shift the AS to the left.
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Activist Policies
• To keep the economy operating close to its full
employment capacity, the government can
utilize fiscal and monetary policies to shift the
AD.
– If AD has shifted to the left because of a drop in C
or I or NX, expansionist fiscal policy (G increase or
T decrease) or stimulative monetary policy
(increasing M/decreasing i) can shift AD to the right.
– The government can also use fiscal and monetary
policies to cancel each other and keep the AD
constant.
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The Problem with Activist Policies
• Monetary policy has long and variable lags.
– Once implemented, it can take six months to two
years for the policy to have an effect on output.
– The impact will last for a long time through
expectations.
• Fiscal policy has political lags.
– Once a policy change is proposed, it has to go
through the Congress.
– It takes months or years to implement it.
– The policy changes in the meantime.
– So does the economy.
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Automatic Stabilizers
• Institutional setup that stimulates the
economy when AD is low and slows the
economy when AD is high.
– The tax system.
– The welfare system.
– The unemployment insurance system.
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Automatic Stabilizers
• Tax system
– During recessions taxes collected fall; during
expansions taxes collected increase.
• Welfare and unemployment
– During recessions these expenditures rise;
during expansions these expenditures fall.
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ATM and Credit Cards
• Proliferation of ATM, credit cards will lower
the checking account balances: money demand
falls.
• Interest rates fall as a result.
• Lower interest rates increase investment
expenditures.
• AD shifts to the right.
• If the Fed wants to counter this development, it
has to sell securities.
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Why Were Interest Rates Low in 1991?
• Could it be that monetary policy was
expansionary?
• No, because 1991 was a recession year.
• During recessions, Md falls because of
lower Y.
• Interest rates fall even if Ms does not
change.
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Fixed Interest Rates
• Suppose government expenditures increase.
–
–
–
–
AD increases.
Y increases.
Md increases.
Interest rates rise.
• Suppose the Fed follows interest rates target.
– The Fed will keep the interest rate constant.
– To lower the interest rate, the Fed will increase the
money supply.
– This will shift the AD further to the right.
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