Transcript The Influence of Monetary and Fiscal Policy on Aggregate Demand

The influence of monetary
and fiscal policy
On Aggregate Demand
Outline
 The influence of (expansionary)
monetary policy on aggregate
demand and on SR fluctuations
 The influence of (expansionary) fiscal
policy on aggregate demand and on
SR fluctuations
 Case of closed economy
 Case of open economy
Fiscal policy and monetary policy
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Fiscal policy: The use of the government’s
tax and expenditure policies in an effort to
influence the behavior of the economy (Ex:
GDP and total employment).
Monetary policy: The use of monetary
variables such as the money supply , and
rate of interest to influence the behavior of
the economy.
How monetary policy influences aggregate
demand? Case of a closed economy
 Recap:
 Aggregate demand curve is downward
sloping due to :
Wealth effect
 Interest rate effect
 RER effect
 In the closed economy, interest effect is
important
 In the open economy, RER effect is
important
How monetary policy influences aggregate
demand? Case of a closed economy
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The most important reason for the downward sloping nature of aggregate demand
is the interest rate effect.
Theory of Liquidity Preference explains that
the interest rate (real and nominal) adjusts
to bring money supply and money demand
into equilibrium. Real and nominal interest
rates move together because the expected
rate of inflation is constant in the SR.
Theory of Liquidity Preference:
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Money supply is fixed by the Central Bank and
is independent of the rate of interest.
Money is demanded for its liquidity (medium of
exchange.
Money demand is inversely related to interest
rate at a given price level and output level .
Interest rate represents the opportunity cost of
holding money.
Money is demanded for its capability to buy
goods and services.
The $ value of transactions (PY) is the other
important determinant of money and causes
shifts in money demanded at a given interest
rate.
Equilibrium in the money market
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Interest rate adjusts to balance the supply and
demand for money.
Theory of Liquidity Preference and
Aggregate Demand
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Increase in prices and interest rate effect:
 A higher price level increases $ value of
transactions and shifts aggregate demand to the
right. This in turn raises the interest rate and
reduces investment in the economy, which in turn
reduces the quantity of goods and services
demanded.
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Interest effect and AD curve (demand for
goods and services)
 Increase in prices ---- Increase in demand for
money--- increase in interest rate--- decrease in qty of
goods and services demanded.
Impact of monetary policy on aggregate
demand in the SR: Closed economy
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Recall:
 Shifts in aggregate demand occur with
changes in consumption, Investment, and Govt
expenditure, net exports at a given price level.
 In an open economy, NX=0
 Changes in C, I, G, and NX can occur through
fiscal policy or monetary policy.
 The Central Bank can change money supply
through:
 Open market operations in the bond market and/ or in
the foreign currency exchange market
 Changes in the Bank Rate
Impact of monetary policy on aggregate
demand in the SR: Closed economy
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Expansionary monetary policy is implemented
by the Central Bank by increasing the money
supply.
The expansionary monetary policy lowers the
interest rate, and increases the quantity of
goods and services demanded for a given
price level.
The contraction monetary policy (Central Bank
contracts money supply) raises the interest rate
and reduces the quantity of goods and
services demanded for a given price level
How monetary policy influences aggregate
demand? Case of open economy
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Recap:
 Interest rate = world interest rate for a small open
economy with perfect capital mobility.
 The most important reasons for the down-ward
sloping nature of aggregate demand are the
interest rate effect and the real exchange rate.
 Increase in prices and RER effect: A higher price
level increases RER and decreases net exports,
which in turn reduces the quantity of goods and
services demanded.
Expansionary monetary policy in an openeconomy with flexible exchange rate
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Expansionary monetary policy by the Central
Bank depreciates the RER causing net exports
to rise. This increases the demand for goods
and services and shifts the aggregate demand
to the right.
The effect of a monetary injection on
aggregate demand is much stronger in an
open economy as compared to a closed
economy.
Expansionary monetary policy in an openeconomy with fixed exchange rate
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Expansionary monetary policy by the Central
Bank depreciates the RER causing net exports
to rise.
Central bank through open market operations
in the foreign- currency exchange market can
hold the value of the domestic currency
constant. This reduces money supply in the
economy.
The Central Bank cannot simultaneously
choose the size of the money supply and the
value of the currency.
Expansionary fiscal policy and aggregate
demand in the SR: Closed economy
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Recap:
 Shifts in aggregate demand at a given price level
occur through changes in C, I, G, and NX.
 Fiscal policy influences C and I by altering spending
decisions of households and firms.
 Changes in govt expenditure (G)alter aggregate
demand directly.
 Increase in govt expenditure--- increases demand
for goods and services- AD shifts to the right.
Govt expenditure and aggregate demand
(AD)
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Size of govt expenditure and size of shift in AD depend
on :
 Multiplier effect (k)
 Crowding-out effect on investment
 Crowding-out effect on NX
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K effect: additional shifts in the AD that result when
expansionary fiscal policy increases income and
thereby increases consumer expenditure
Crowding-out effect on investment: offset in the AD
that results when expansionary fiscal policy raises the
interest rate and thereby reduces investment
expenditure
Crowding-out effect on NX: offset in the AD that results
when expansionary fiscal policy in a small open
economy with flexible exchange rate raises the RER
and thereby reduces net exports
Multiplier effect
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Increase in income is spent on consumption and
savings.
K= 1/1-MPC in a closed economy
MPC= Marginal propensity to consume
In a closed economy, k is directly proportional to MPC
K= 1/1-MPC+MPI in an open economy
MPI= Marginal propensity to import
In an open economy, k is indirectly proportional to MPI
In general, the aggregate demand for goods and
services rises by more than the govt expenditure due to
the k effect
Illustration: see example done in class
Crowding-out effect on investment
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Increase in govt expenditure causes rise in rate
of interest and reduces residential and business
investment expenditure thus choking off
aggregate demand.
If crowding out effect on investment is larger
than the k effect, then AD for goods and
services will rise by less than govt purchases.
Crowding-out effect on NX
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In a small open economy with perfect capital
mobility, increase in govt expenditure causes a
rise in the rate of interest thus raising domestic
interest rate above the world interest rate.
If the exchange rate is flexible, this causes an
appreciation in the RER and reduces net
exports and thereby the aggregate demand
for goods and services.
Fiscal policy and effect on aggregate demand in
a closed economy
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Expansionary fiscal policy is undertaken
through an increase in govt expenditure on
public works/ job creation programs.
The size of shift in AD depends on the size of the
k and the size of the crowding-out effect on
investment.
An increase in govt purchases increases the
demand for goods and services by the value
of the k thus raising the demand for money
and interest rate. The rise in interest rate crowds
out investment and AD shifts to the left at a
given price level.
Fiscal policy and effect on aggregate demand in
an open economy: Flexible exchange rate
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In a small open economy, expansionary fiscal
policy causes
Crowding out effect on investment due to an
increase in domestic interest rate (> than world
interest rate)
 crowding out effect on NX due to an appreciation
in the RER.
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Expansionary fiscal policy has no lasting effect
on on the position of the aggregate demand
curve
Fiscal policy and effect on aggregate demand in
an open economy: Fixed exchange rate
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In a small open economy, expansionary fiscal policy
causes domestic interest rate to rise above world
interest rate. This appreciates the RER.
The Central Bank through open market operations in
the foreign currency exchange market (purchase of
foreign currency) increases the supply of domestic
currency and prevents changes in the exchange rate.
Thus, the Bank prevents crowding out effect on NX.
The supply of domestic currency by the Central bank
causes domestic interest rate to fall and equal world
interest rate.
Thus, the Bank prevents crowding out effect on
investment.
The increase in money supply shifts the AD curve even
farther to the right.
Fiscal policy and effect on aggregate demand in
an open economy: Fixed exchange rate
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With a fixed exchange rate, an expansionary
fiscal policy will have no crowding-out effects
and will therefore cause a large increase in the
demand for goods and services.
Coordination of Monetary and Fiscal policy
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For fiscal policy to have a lasting effect on the
AD curve, the Central Bank must choose the
appropriate exchange rate policy.
Changes in taxes: reduction in taxes
stimulates consumer expenditure through the
multiplier effect
crowds out net exports by increasing RER
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Deficit reduction
 Balanced budget limits the government’s options to
increase AD.
 Deficit reduction will have no long lasting impact on
AD in the event of a flexible exchange rate policy.
Stabilization Policy
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In theory, monetary policy and fiscal policy can be
used to stabilize (offset) the effects of shocks to the
Canadian economy.
Identifying the shock and its affects and
determining an appropriate response is often
difficult.
Monetary policy, although quickly implemented,
affects the economy with considerable lags ( 1/2 to
1 1/2 years).
Fiscal policy has a long implementation lag. Effects
of policies are themselves uncertain.
Stabilization Policy: Current situation
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Active fiscal policy rarely used for aggregate demand
management.
Monetary policy’s primary focus is to maintain an
inflation target while minimizing the effects of
monetary policy on aggregate demand.
Automatic stabilizers in place to minimize AD
fluctuations.
Taxes and transfers: when AD is low, taxes fall and
transfers increase offsetting some of the low AD.
Flexible exchange rate: an external AD shock
(fall/rise in NX) is offset by exchange rate adjustment.