Monetary and Fiscal Policies MBA MACROECONOMICS JACK WU

Short-Run Economic Fluctuation Economic activity fluctuates from year to year. A recession is a period of declining real incomes, and rising unemployment. A depression is a severe recession. • Fluctuations in the economy are often called the business cycle.

Basic Model Two variables are used to develop a model to analyze the short-run fluctuations. The economy’s output of goods and services measured by real GDP. The overall price level measured by the CPI or the GDP deflator. The Basic Model of Aggregate Demand Aggregate Supply Economist use the model of aggregate demand aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

Aggregate Demand Supply Curves The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

Aggregate Demand Aggregate Supply Price Level Aggregate supply Equilibrium price level Aggregate demand 0

Aggregate Demand Curve The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

The Aggregate-Demand Curve. . . Price Level P P 2 1. A decrease in the price level. . . Aggregate demand 0 Y Y 2 2. . increases the quantity of goods and services demanded. Quantity of Output Copyright © 2004 South-Western

Shifts arising from Consumption Investment Government Purchases Net Exports

Demand Curve Shifts Price Level P 1 D 2 Aggregate demand, D 1 0 Y 1 Y 2 Quantity of Output

Aggregate Supply Curve In the long run, the aggregate-supply curve is vertical. In the short run, the aggregate-supply curve is upward sloping.

The Long-Run Aggregate-Supply Curve Price Level Long-run aggregate supply P P 2 2. . does not affect the quantity of goods and services supplied in the long run. 1. A change in the price level. . . 0 Natural rate of output Quantity of Output Copyright © 2004 South-Western

Long-Run Aggregate Supply Curve The Long-Run Aggregate-Supply Curve The long-run aggregate-supply curve is vertical at the natural rate of output. This level of production is also referred to as potential output or full-employment output. Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve. The shifts may be categorized according to the various factors in the classical model that affect output.

Shifts arising Labor Capital Natural Resources Technological Knowledge

Long-Run Growth and Inflation 2. . and growth in the money supply shifts aggregate demand. . . Long-run aggregate supply, LRAS 1980 LRAS 1990 LRAS 2000 Price Level 1. In the long run, technological progress shifts long-run aggregate supply. . . P 2000 4. . and ongoing inflation. P 1990 Aggregate Demand, AD 2000 P 1980 AD 1990 AD 1980 0 Y 1980 Y 1990 Quantity of Output 3. . leading to growth in output. . . Y 2000 Copyright © 2004 South-Western

Short-Run Aggregate Supply Curve Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends. In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied. A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

The Short-Run Aggregate-Supply Curve Price Level Short-run aggregate supply P P 2 2. . reduces the quantity of goods and services supplied in the short run. 1. A decrease in the price level. . . 0 Y 2 Y Quantity of Output Copyright © 2004 South-Western

The Long-Run Equilibrium Price Level Long-run aggregate supply Equilibrium price Short-run aggregate supply A Aggregate demand 0 Natural rate of output Quantity of Output Copyright © 2004 South-Western

Two Causes of Economic Fluctuation Shifts in Aggregate Demand In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. In the long run, shifts in aggregate demand affect the overall price level but do not affect output. An Adverse Shift in Aggregate Supply A decrease in one of the determinants of aggregate supply shifts the curve to the left: Output falls below the natural rate of employment. Unemployment rises. The price level rises

A Contraction in Aggregate Demand 2. . causes output to fall in the short run. . . Price Level Long-run aggregate supply Short-run aggregate supply, AS AS 2 3. . but over time, the short-run aggregate-supply curve shifts. . . A P B P 2 P 3 1. A decrease in aggregate demand. . . C Aggregate demand, AD AD 2 0 Y 2 Y 4. . and output returns to its natural rate. Quantity of Output Copyright © 2004 South-Western

An Adverse Shift in Aggregate Supply 1. An adverse shift in the shortrun aggregate-supply curve. . . Price Level Long-run aggregate supply P 2 AS 2 Short-run aggregate supply, AS B A P 3. . and the price level to rise. Aggregate demand 0 2. . causes output to fall. . . Y 2 Y Quantity of Output Copyright © 2004 South-Western

Stagflation Adverse shifts in aggregate supply cause stagflation—a period of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

Policy Responses to Recession Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using monetary and fiscal policy.

Accommodating an Adverse Shift in Aggregate Supply 1. When short-run aggregate supply falls. . . Price Level Long-run aggregate supply P 3 C P 2 3. . which P causes the price level to rise further. . . 0 A 4. . but keeps output at its natural rate. Natural rate of output Short-run aggregate supply, AS AS 2 2. . policymakers can accommodate the shift by expanding aggregate demand. . . AD 2 Aggregate demand, AD Quantity of Output Copyright © 2004 South-Western

Equilibrium in the Money Market Interest Rate Money supply r 1 Equilibrium interest rate

Price and Quantity Demanded The price level is one determinant of the quantity of money demanded. A higher price level increases the quantity of money demanded for any given interest rate. Higher money demand leads to a higher interest rate. The quantity of goods and services demanded falls. The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded.

The Money Market and the Slope of the Aggregate. Demand Curve (a) The Money Market Interest Rate (b) The Aggregate-Demand Curve Price Level Money supply 2. . increases the demand for money. . . P 2 r 3. . which increases the equilibrium 0 interest rate. . . Money demand at price level P 2 , MD 2 Money demand at price level P , MD Quantity fixed by the Fed Quantity of Money 1. An P increase in the price level. . . 0 Aggregate demand Quantity of Output 4. . which in turn reduces the quantity of goods and services demanded. Y 2 Y Copyright © 2004 South-Western

Fed’s Monetary Injection The Fed can shift the aggregate demand curve when it changes monetary policy. An increase in the money supply shifts the money supply curve to the right. Without a change in the money demand curve, the interest rate falls. Falling interest rates increase the quantity of goods and services demanded.

A Monetary Injection (b) The Aggregate-Demand Curve (a) The Money Market Interest Rate r 2. . the equilibrium interest rate falls. . . Money supply, MS Price Level MS 2 1. When the Fed increases the money supply. . . P r 2 AD 2 Money demand at price level P 0 Quantity of Money Aggregate demand, AD 0 Y Y Quantity of Output 3. . which increases the quantity of goods and services demanded at a given price level. Copyright © 2004 South-Western

Impacts of Monetary Policy on Aggregate Demand When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the right. When the Fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the left.

Forms of Monetary Policy Monetary policy can be described either in terms of the money supply or in terms of the interest rate. Changes in monetary policy can be viewed either in terms of a changing target for the interest rate or in terms of a change in the money supply. A target for the federal funds rate affects the money market equilibrium, which influences aggregate demand.

Fiscal Policy Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes. Fiscal policy influences saving, investment, and growth in the long run. In the short run, fiscal policy primarily affects the aggregate demand.

Fiscal Policy: continued When policymakers change the money supply or taxes, the effect on aggregate demand is indirect— through the spending decisions of firms or households. When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly.

Two Macroeconomic Effects There are two macroeconomic effects from the change in government purchases: The multiplier effect The crowding-out effect

The Multiplier Effect Price Level 2. . but the multiplier effect can amplify the shift in aggregate demand. $20 billion AD 3 AD 2 Aggregate demand, AD 1 0 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion. . . Quantity of Output Copyright © 2004 South-Western

The Crowding-Out Effect (a) The Money Market Interest Rate Money supply r 2 3. . which increases the equilibrium interest rate. . . (b) The Shift in Aggregate Demand Price Level 2. . the increase in spending increases money demand. . . $20 billion 4. . which in turn partly offsets the initial increase in aggregate demand. AD 2 r AD 3 MD 2 Aggregate demand, AD 1 Money demand, MD 0 Quantity fixed by the Fed Quantity of Money 0 1. When an increase in government purchases increases aggregate demand. . . Quantity of Output Copyright © 2004 South-Western