Chapter 35

Monetary Policy Fiscal Policy

and Aggregate Demand

Key Termstheory of liquidity preferencefiscal policesmultiplier effectcrowding-out effectautomatic stabilizers

Equations

MPC + MPS = 1

Multiplier = 1÷1-MPC or 1÷MPS

automatic 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

r

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 Consume MPC

New income = spend + saveHow much do you spend?

75 percentThen you will be saving 25 percent

Marginal Propensity to Consume plus

Marginal Propensity to Save equals one

MPC + MPS = 1 1- MPS = MPC 1- MPC = MPS

Multiplier

1÷ 1-MPCor

1÷ 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 = .75

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?

TaxBorrow

Reduces IncomeIncreases interest

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

PriceLevel

Quantity of Output

PL

Y3 Y1 Y2

Government SpendingMultiplier Effect

Government SpendingCrowding-Out EffectTaxes & Borrowing

Automatic Stabilizers

Changes in fiscal policy that stimulate aggregate demand

when the economy goes into a recession

Quiz 8 Name ID1. If the MPC is .7, what is the MPS?

2. If the MPC is .8, what will total new spending be if the government spends 100 riyals?

3. If the money supply increases, what happens to interest rates?

4. If the price level increases what happens to interest rates?

5. What is the crowding-out effect?

6. Who is the father of Macroeconomics?

7. What two things happen to Aggregate Demand when government borrows money to spend?

Physical Financial Human Intellectual Cultural Entrepreneural Total

Saudi Arabia

Qatar

U.A. E.

Jordan

Kuwait

Iraq

Egypt

Capital Analysis Scale 1-10 each category1=lowest, 10=highest