Monetary and Fiscal Policy Interact Unit 5 Lesson

Monetary and Fiscal Policy Interact Unit 5 Lesson 2 Activity 45 By John Morton Advanced Placement Economics Teacher Resource Manual. National Council on Economic Education, New York, N. Y

The Effects of Policy Changes in Multiple Markets Loanable Funds Market AD and AS Interest Rate PL Interest Rate SRAS p Money Market MS S i MD Y AD GDPR D I Loanable Funds Money • Suppose that, in response to the economic situation, the federal government decides to increase its spending without increasing taxes and the Fed keeps the money supply constant. • Explain what would happen in the three markets shown above.

Loanable Funds Market AD and AS Interest Rate PL SRAS p 1 p Interest Rate Money Market MS S i 1 i D 1 AD 1 Y Y 1 AD GDPR D I I 1 Loanable Funds MD 1 MD Money • The AD curve should shift to the right. • Increase the demand for loanable funds by shifting the curve to the right. • The demand for money should also shift to the right. • The interest rates in the money market and loanable funds should be equal.

Loanable Funds Market AD and AS Interest Rate SRAS p 1 p Interest Rate Money Market MS S i 1 i D 1 AD 1 Y Y 1 AD GDPR D I I 1 Loanable Funds MD 1 MD Money 2. What happened to each of the following variables and why: A. Output (real GDP): Increased. AD increased because of the increase in government spending

Loanable Funds Market AD and AS Interest Rate SRAS p 1 p Interest Rate i D 1 AD 1 Y Y 1 MS S i 1 AD GDPR Money Market D I I 1 Loanable Funds MD 1 MD Money B. Unemployment: Decreased. AD increased because of the increase in government spending C. Price level: Increased. AD increased because of the increase in government spending

Loanable Funds Market AD and AS Interest Rate SRAS p 1 p Interest Rate i 1 D 1 AD 1 Y Y 1 MS S i AD GDPR Money Market D I I 1 Loanable Funds MD 1 MD Money D. Interest rates: Increased. With the money supply held constant, the demand for money increased or the demand for loanable funds increased.

Loanable Funds Market AD and AS Interest Rate SRAS p 1 p Interest Rate Money Market S i 1 i D 1 AD 1 Y Y 1 AD GDPR MS D I I 1 Loanable Funds E. Investment: Decreased because of the increase in interest rates MD 1 MD Money

Loanable Funds Market AD and AS Interest Rate SRAS p 1 p Interest Rate MS S i 1 i D 1 AD 1 Y Y 1 • Money Market AD GDPR D I I 1 Loanable Funds Was there crowding-out present in the above graphs? • In the Loanable Funds Market graph, the government’s demand for funds increased the interest rate. MD 1 MD Money

4. Answer the following questions: A. What could the Fed have done to prevent crowding-out? The Fed could use expansionary monetary policy; thus the government’s demand for funds would not result in an increase in interest rates. A. Are there certain conditions when the Fed should or should not prevent crowding-out? If the economy were experiencing a recession, the Fed would want to prevent crowding-out, but if the economy were at or near full employment and government spending increased, the Fed might not want to prevent crowding-out.

Graphing Monetary and Fiscal Policy Interactions • Illustrate the short-run effects for each monetary and fiscal policy combination using AD and AS curves, the money market and the loanable funds market. • Once again, assume that there are no changes in the foreign sector. • Circle the appropriate symbols (↑ for increase, ↓ for decrease, and ? for uncertain), and explain the effect of the policies on real GDP, the price level, unemployment, interest rates and investment.

1. The unemployment rate is 10%, and the CPI is increasing at a 2% rate. The federal government cuts personal income taxes and increase its spending. The Fed buys bonds on the open market. PL Loanable Funds Market AD and AS Interest Rate SRAS p Money Market MS S i Y AD GDPR D I MD Loanable Funds Money

Expansionary Monetary and Fiscal Policy PL AD and AS Interest Rate SRAS p 1 p AD 1 Y Y 1 AD GDPR (A) Real GDP: S i 1 i I ? MS MS 1 D 1 D Money Market MD Loanable Funds Explain Both policies are expansionary: C, G & I will all increase. MD 1

Expansionary Monetary and Fiscal Policy PL AD and AS Interest Rate SRAS p 1 p AD 1 Y Y 1 S i 1 i AD GDPR (B) The Price Level: Money Market MS MS 1 D 1 D I MD Loanable Funds ? Explain The increase in AD will increase the PL MD 1

Expansionary Monetary and Fiscal Policy PL AD and AS Interest Rate SRAS p 1 p AD 1 Y Y 1 S i 1 i AD GDPR (C) Unemployment: I MS MS 1 D 1 D Money Market MD Loanable Funds ? The increase in AD will decrease unemployment and output. Explain MD 1

Expansionary Monetary and Fiscal Policy PL AD and AS Interest Rate SRAS p 1 p AD 1 Y Y 1 S i 1 i AD GDPR (D) Interest Rates: I MS MS 1 D 1 D Money Market MD MD 1 Loanable Funds ? Explain Fiscal policy would result in an increase in interest rates; monetary policy would result in lower interest rates. The net effect depends on the relative strength of the two policies. The graph here shows a slight increase in interest rates; the effect on interest rates is indeterminate.

Expansionary Monetary and Fiscal Policy PL AD and AS Interest Rate SRAS p 1 p AD 1 Y Y 1 AD GDPR (E) Investment: S i 1 i I MS MS 1 D 1 D Money Market MD Loanable Funds ? Explain Because we can’t tell what happens to interest rates, we can’t say what happens to investment because of changes in the interest rate. MD 1

2. The unemployment rate is 6%, and the CPI is increasing at a 9% rate. The federal government raises personal income taxes and cuts spending. The Federal Reserve sells bonds on the open market. PL Loanable Funds Market AD and AS Interest Rate SRAS p Money Market MS S i AD Y GDPR D I Loanable Funds MD Money

Contractionary Monetary and Fiscal Policy PL Loanable Funds Market AD and AS Interest Rate S 1 SRAS p Interest Rate Money Market MS 1 MS S i p 1 AD AD 1 Y GDPR (A) Real GDP: MD D D 1 I Loanable Funds ? MD 1 Money Explain Decreased AD should lower GDP somewhat. AD decreases because of contractionary monetary and fiscal policy.

Contractionary Monetary and Fiscal Policy PL Loanable Funds Market AD and AS Interest Rate SRAS p Interest Rate S 1 Money Market MS 1 MS S i p 1 AD AD 1 Y GDPR (B) The Price Level: MD D D 1 I Loanable Funds ? MD 1 Money Explain The decrease in AD should result in a lower PL

Contractionary Monetary and Fiscal Policy PL Loanable Funds Market AD and AS Interest Rate SRAS p Interest Rate S 1 Money Market MS 1 MS S i p 1 AD AD 1 Y GDPR (C) Unemployment: MD D D 1 I Loanable Funds ? MD 1 Money Explain Lower output increases unemployment on the SRAS curve.

Contractionary Monetary and Fiscal Policy PL Loanable Funds Market AD and AS Interest Rate SRAS p Interest Rate S 1 Money Market MS 1 MS S i p 1 AD AD 1 Y GDPR (D) Interest rates: MD D D 1 I Loanable Funds ? MD 1 Money Explain The Fed decreases the money supply, which should result in an increase in interest rates. The increase in taxes and decrease in government spending result in a decrease in interest rates since the demand for loanable funds by the government should decrease. The demand for money decrease because of the decrease I real GDP. Interest rates will be higher if the decrease in demand is less than the decrease in supply in the money market. The interest rate effect is indeterminate.

Contractionary Monetary and Fiscal Policy PL Loanable Funds Market AD and AS Interest Rate SRAS p Interest Rate S 1 Money Market MS 1 MS S i p 1 AD AD 1 Y GDPR (E) Investment: MD D D 1 I Loanable Funds ? MD 1 Money Explain If interest rates are higher; there would be a decrease in the level of investment. If interest rates are lower, there would be an increase.

3. The unemployment rate is 6%, and the CPI is increasing at a 5% rate. The federal government cuts personal income taxes and maintains current spending. The Fed sells bonds on the open market. PL Loanable Funds Market AD and AS Interest Rate Money Market MS SRAS p i AD Y GDPR D I Loanable Funds MD Money

Contractionary Monetary Policy and Expansionary Fiscal Policy PL Loanable Funds Market AD and AS Interest Rate SRAS p Interest Rate S 1 i 1 Money Market MS 1 MS S i AD Y GDPR (A) Real GDP: D D 1 MD Loanable Funds I ? Money Explain The combined effect on AD is impossible to predict. The fiscal policy is expansionary, and the monetary policy is contractionary.

Contractionary Monetary Policy and Expansionary Fiscal Policy PL Loanable Funds Market AD and AS Interest Rate SRAS p Interest Rate S 1 i 1 Money Market MS 1 MS S i AD Y GDPR (B) Price Level: D D 1 MD Loanable Funds I ? Explain The impact on the price level is impossible to predict given the contradicting monetary and fiscal policies. Money

Contractionary Monetary Policy and Expansionary Fiscal Policy PL Loanable Funds Market AD and AS Interest Rate SRAS p Interest Rate S 1 i 1 Money Market MS 1 MS S i AD Y GDPR (C) Unemployment: D I D 1 MD Loanable Funds ? Explain The impact on output and, hence, employment is impossible to predict given the contradicting monetary and fiscal policies. Money

Contractionary Monetary Policy and Expansionary Fiscal Policy PL Loanable Funds Market AD and AS Interest Rate SRAS p Interest Rate S 1 i 1 Money Market MS 1 MS S i AD Y GDPR (D) Interest rates: D I D 1 MD Loanable Funds ? Money Explain Interest rates will rise because of the increased demand for and reduced supply of loanable funds.

Contractionary Monetary Policy and Expansionary Fiscal Policy PL Loanable Funds Market AD and AS Interest Rate SRAS p Interest Rate S 1 i 1 Money Market MS 1 MS S i AD Y GDPR (E) Investment: D I D 1 MD Loanable Funds ? Money Explain The increase in interest rates will tend to decrease investments.