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Chapter 35
Monetary PolicyFiscal Policy
andAggregate Demand
Key Termstheory of liquidity preferencefiscal policesmultiplier effectcrowding-out effectautomatic stabilizers
Economic Cycle
Aggregate Demand
Wealth EffectInterest-Rate Effect
Exchange-Rate Effect
John Maynard Keynes(1883 - 1946)
Father of Macroeconomics
The General Theory of Employment,
Interest and Money
The ideas of economists and political philosophers are more powerful than commonly understood; indeed the world is ruled by little else.
Theory of Liquidity Preference
Interest rates adjust to bring money supply and money demanded into
balance
Interest Rates
Nominal = Real + Inflation
If inflation is zero, then nominal = real
Money Supply
Discount RateBond MarketReserve Ratio
InterestRate
Quantity of MoneyMD1
Money Market
MD2
r1
r2
MoneySupply
MoneyDemand
Quantity fixed by the Central
Bank
EquilibriumInterest
Rate
Liquidity Theory1. Money Supply is fixed by central bank with policy tools (Debt Instrument Market, Discount Rate, Reserve Requirement)
2. Money Demand - Liquidity - Interest rate is the opportunity cost of holding money.
3. Equilibrium pressures
InterestRate
Quantity of Money
Money Market
r2
MoneySupply
MoneyDemand
Quantity fixed by the Central
Bank
r1
r3
MoneyDemand
InterestRate
Quantity of Money
Money Market
r2
MoneySupply
Quantity fixed by the Central
Bank
r1
r3
MoneyDemand
InterestRate
Quantity of Money
Money Market
r2
MoneySupply
r1
r3
InterestRate
1. Price level increases2. Increases demand for money3. Increases interest rate4. Reduces quantity demand of output
Money Market
r2
MoneySupply
MoneyDemand
Quantity fixed by the Central Bank
r1
PriceLevel
P2
AggregateDemand
OutputY2
P1
Y1
Aggregate Demand
Fiscal Policies
Level of government spending and taxing
Multiplier Effect
Additional shifts in aggregate demand due to expansionary government
spending
Marginal Propensity to ConsumeMPC
New income = spend + saveHow much do you spend?
75 percentThen you will be saving 25 percent
Marginal Propensity to Consumeplus
Marginal Propensity to Saveequals one
MPC + MPS = 11- MPS = MPC1- MPC = MPS
Earn Spend Total Spending
1 100.0 75.0 75.0
2 75.0 56.3 131.3
3 56.3 42.2 173.4
4 42.2 31.6 205.1
5 31.6 23.7 228.8
6 23.7 17.8 246.6
7 17.8 13.3 260.0
8 13.3 10.0 270.0
9 10.0 7.5 277.5
10 7.5 5.6 283.1
11 5.6 4.2 287.3
Multiplier
1/(1-MPC)
Remember 1-MPC = MPS
ThereforeMultiplier
also1/MPS
MPC MPS Total Spending
1.00 0.00 infinite
0.90 0.10 10.00
0.80 0.20 5.00
0.75 0.25 4.00
0.60 0.40 2.50
0.50 0.50 2.00
0.40 0.60 1.67
0.30 0.70 1.43
0.25 0.75 1.33
0.10 0.90 1.11
0.50 0.50 2.00
Multiplier
1/(1-MPC)
Remember 1-MPC = MPS
ThereforeMultiplier
also1/MPS
Multiplier Effect
1. Works with C, I, G, and NX2. Goes both ways
Where does the money come from?
TaxBorrowPrint
Reduces IncomeIncreases interestInflation
Crowding-Out can be larger than the
Multiplier
Aggregate Demand shifts left
Crowding-out Effect
Offsetting aggregate demand when fiscal
expansion raises interest rates and reduces spending
Automatic Stabilizers
Changes in fiscal policy that stimulate aggregate demand
when the economy goes into a recession
