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Monetary and fiscal policy ppt @ becdoms
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Monetary and Fiscal Policies
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
and Aggregate Supply Economist use the model of aggregate demand and
aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.
Aggregate Demand and 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 and Aggregate Supply
Quantity ofOutput
PriceLevel
0
Aggregatesupply
Aggregatedemand
Equilibriumoutput
Equilibriumprice level
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...
Quantity ofOutput
PriceLevel
0
Aggregatedemand
P
Y Y2
P2
1. A decreasein the pricelevel . . .
2. . . . increases the quantity ofgoods and services demanded.
Shifts Shifts arising from
Consumption Investment Government Purchases Net Exports
Demand Curve Shifts
Quantity ofOutput
PriceLevel
0
Aggregatedemand, D1
P1
Y1
D2
Y2
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
Quantity ofOutput
Natural rateof output
PriceLevel
0
Long-runaggregate
supply
P2
1. A changein the pricelevel . . .
2. . . . does not affect the quantity of goods and services supplied in the long run.
P
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 Shifts arising
Labor Capital Natural Resources Technological Knowledge
Long-Run Growth and Inflation
Quantity ofOutput
Y1980
AD1980
AD1990
Aggregate Demand, AD2000
PriceLevel
0
Long-runaggregate
supply,LRAS1980
Y1990
LRAS1990
Y2000
LRAS2000
P1980
1. In the long run,technological progress shifts long-run aggregate supply . . .
4. . . . andongoing inflation.
3. . . . leading to growthin output . . .
P1990
P2000
2. . . . and growth in the money supply shifts aggregate demand . . .
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
Quantity ofOutput
PriceLevel
0
Short-runaggregate
supply
1. A decreasein the pricelevel . . .
2. . . . reduces the quantityof goods and services
supplied in the short run.
Y
P
Y2
P2
The Long-Run Equilibrium
Natural rateof output
Quantity ofOutput
PriceLevel
0
Short-runaggregate
supply
Long-runaggregate
supply
Aggregatedemand
AEquilibriumprice
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
Quantity ofOutput
PriceLevel
0
Short-run aggregatesupply, AS
Long-runaggregate
supply
Aggregatedemand, AD
AP
Y
AD2
AS2
1. A decrease inaggregate demand . . .
2. . . . causes output to fall in the short run . . .
3. . . . but over time, the short-runaggregate-supplycurve shifts . . .
4. . . . and output returnsto its natural rate.
CP3
BP2
Y2
An Adverse Shift in Aggregate Supply
Quantity ofOutput
PriceLevel
0
Aggregate demand
3. . . . and the price level to rise.
2. . . . causes output to fall . . .
1. An adverse shift in the short-run aggregate-supply curve . . .
Short-runaggregate
supply, AS
Long-runaggregate
supply
Y
AP
AS2
B
Y2
P2
Stagflation 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 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
Quantity ofOutput
Natural rateof output
PriceLevel
0
Short-runaggregate
supply, AS
Long-runaggregate
supply
Aggregate demand, AD
P2
AP
AS2
3. . . . whichcauses theprice level to rise further . . .
4. . . . but keeps outputat its natural rate.
2. . . . policymakers canaccommodate the shiftby expanding aggregatedemand . . .
1. When short-run aggregatesupply falls . . .
AD2
CP3
Copyright © 2004 South-Western
Equilibrium in the Money Market
Quantity ofMoney
InterestRate
0
Moneydemand
Quantity fixedby the Fed
Moneysupply
r2
M2dMd
r1
Equilibriuminterest
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
Quantityof Money
Quantity fixedby the Fed
0
InterestRate
Money demand at price level P2, MD2
Money demand atprice level P , MD
Moneysupply
(a) The Money Market (b) The Aggregate-Demand Curve
3. . . . whichincreasesthe equilibriuminterestrate . . .
2. . . . increases thedemand for money . . .
Quantityof Output
0
PriceLevel
Aggregatedemand
P2
Y2 Y
P
4. . . . which in turn reduces the quantityof goods and services demanded.
1. Anincreasein thepricelevel . . .
r
r2
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
MS2Moneysupply, MS
Aggregatedemand, AD
YY
P
Money demand at price level P
AD2
Quantityof Money
0
InterestRate
r
r2
(a) The Money Market (b) The Aggregate-Demand Curve
Quantityof Output
0
PriceLevel
3. . . . which increases the quantity of goods and services demanded at a given price level.
2. . . . theequilibriuminterest ratefalls . . .
1. When the Fedincreases themoney supply . . .
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
Quantity ofOutput
PriceLevel
0
Aggregate demand, AD1
$20 billion
AD2
AD3
1. An increase in government purchasesof $20 billion initially increases aggregatedemand by $20 billion . . .
2. . . . but the multipliereffect can amplify theshift in aggregatedemand.
The Crowding-Out Effect
Quantityof Money
Quantity fixedby the Fed
0
InterestRate
r
Money demand, MD
Moneysupply
(a) The Money Market
3. . . . whichincreasesthe
equilibriuminterestrate . . .
2. . . . the increase inspending increasesmoney demand . . .
MD2
Quantityof Output
0
PriceLevel
Aggregate demand, AD1
(b) The Shift in Aggregate Demand
4. . . . which in turnpartly offsets theinitial increase inaggregate demand.
AD2
AD3
1. When an increase in government purchases increases aggregatedemand . . .
r2
$20 billion
