Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001)

1. Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 15: The Influence of Monetary and Fiscal Policy on Aggregate Demand

2. 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. Econ 202 Dr. Ugur Aker

3. 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. Econ 202 Dr. Ugur Aker

4. 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? Econ 202 Dr. Ugur Aker

5. 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. Econ 202 Dr. Ugur Aker

6. 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. Econ 202 Dr. Ugur Aker

7. 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. Econ 202 Dr. Ugur Aker

8. 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. Econ 202 Dr. Ugur Aker

9. 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. Econ 202 Dr. Ugur Aker

10. 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. Econ 202 Dr. Ugur Aker

11. 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. Econ 202 Dr. Ugur Aker

12. 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. Econ 202 Dr. Ugur Aker

13. 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. Econ 202 Dr. Ugur Aker

14. 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. Econ 202 Dr. Ugur Aker

15. 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. Econ 202 Dr. Ugur Aker

16. Money Demand i Real income increase Price level increase M Econ 202 Dr. Ugur Aker

17. Equilibrium in the Money Sector i Ms i* Md M Econ 202 Dr. Ugur Aker

18. Equilibrium in the Money Sector i Ms 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? i1 i* i2 Md M Econ 202 Dr. Ugur Aker

19. 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. Econ 202 Dr. Ugur Aker

20. 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. Econ 202 Dr. Ugur Aker

21. 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. Econ 202 Dr. Ugur Aker

22. Connection of Monetary Sector Equilibrium and Aggregate Demand i P 6% 6% Md at P=150 Y=3000 150 4% 4% 100 Md at P=100 Y=3000 Ms Y M 3000 Econ 202 Dr. Ugur Aker

23. Labor, capital and technology determine the output (GDP). The loanable funds market determines the interest rate. Price level is determined by supply and demand for money. The price level is sticky in the short-run. Given the price level, interest rate adjusts to balance supply and demand for money. Aggregate demand determines the output. Long-Run vs. Short-Run Econ 202 Dr. Ugur Aker

24. Increasing Ms Shifts AD Right i P Ms1 Ms2 7% P AD2 4% Md AD1 Y1 Y2 Econ 202 Dr. Ugur Aker

25. 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. Econ 202 Dr. Ugur Aker

26. 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. Econ 202 Dr. Ugur Aker

27. 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. Econ 202 Dr. Ugur Aker

28. 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. Econ 202 Dr. Ugur Aker

29. 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. Econ 202 Dr. Ugur Aker

30. 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. Econ 202 Dr. Ugur Aker

31. 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. Econ 202 Dr. Ugur Aker

32. The Multiplier Effect Econ 202 Dr. Ugur Aker

33. The Multiplier Effect P AD3 AD2 AD1 1010 Y 1000 1100 Econ 202 Dr. Ugur Aker

34. 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. Econ 202 Dr. Ugur Aker

35. 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. Econ 202 Dr. Ugur Aker

36. 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. Econ 202 Dr. Ugur Aker

37. The Crowding-Out Effect P i AD2 Ms AD3 P1 i2 i1 Md AD1 Md Y2 Y1 Y3 Y M Econ 202 Dr. Ugur Aker

38. 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) • 1- MPC = 1/5 • MPC = - 0.8 • MPC = 0.8 ΔY = mΔG 50 = m10 m = 50/10 m = 5 Econ 202 Dr. Ugur Aker

39. 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. Econ 202 Dr. Ugur Aker

40. Effects of Tax Cuts • A tax cut will increase consumption. • Increased consumption will have multiplier effect. • Higher income generated will have crowding-out 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. Econ 202 Dr. Ugur Aker

41. 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. Econ 202 Dr. Ugur Aker

42. 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. Econ 202 Dr. Ugur Aker

43. 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. Econ 202 Dr. Ugur Aker

44. 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. Econ 202 Dr. Ugur Aker

45. 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. Econ 202 Dr. Ugur Aker

46. 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. Econ 202 Dr. Ugur Aker

47. 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. Econ 202 Dr. Ugur Aker

48. 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. Econ 202 Dr. Ugur Aker