Fiscal & Monetary Policy with aGoods & Services Market

&Money Market

Lecture 18Jennifer P. Wissink

©2015 Jennifer P. Wissink, all rights reserved.

October 27, 2015

The Goods & Services Market (AEd) &The Money Market

From Money Market we get r* where MD(r, Y, PL) = MS

From G&S market we get Y* where Y* = AEd = C(Yd)+Id(r)+G+EX–IM

Note:– Id depends negatively on the interest rate, r.

» Why? When r increases, investment projects have lower present value and look less attractive.

Recall:– MD depends positively on Y&PL and depends negatively on r.

Now we have ties (r, Y and PL) that bind the Money Market to the Goods and Services Market!

The Goods & Services Market (AEd) & The Money Market & POLICY (both Monetary and Fiscal)

There are equilibrium values of Y*, output(income), & the interest rate, r*, that are consistent with the existence of equilibrium in both markets, simultaneously.

Now POLICY is more complicated and interesting– Suppose Y* < YFE expansionary policy considered

» monetary and/or fiscal

– Suppose Y* > YFE contractionary policy considered» monetary and/or fiscal

Expansionary Policy

Expansionary fiscal policy is either an increase in government spending and/or a reduction in net taxes aimed at increasing Y*

Expansionary monetary policy is an increase in the money supply aimed at increasing Y*– Sometimes called “easy monetary policy”

Contractionary Policy

Contractionary fiscal policy is either a decrease in government spending and/or an increase in net taxes aimed at decreasing Y*

Contractionary monetary policy is a decrease in the money supply aimed at decreasing Y*– Sometimes called “tight monetary policy”

An INCREASE in MS (Fed buys up bonds via OMO)

Ms r Id AEd Y

– MD r Id AEd Y

Finally: get a new lower r* and higher Y* Note: with feedback effect, there is a

smaller final change in r* and Y* So, efficacy of monetary policy depends

on some important sensitivities!

45° help

An INCREASE in G G AEd Y

– MD r Id AEd Y

Finally… get a new higher r* and higher Y*

Note: with feedback effect, there is a smaller final change in Y*

45° help

Issue: The Crowding-Out Effect of Expansionary Fiscal Policy

The crowding-out effect is the tendency for increases in government spending to cause reductions in private investment spending.

The crowding-out effect depends on the sensitivity or insensitivity of planned investment spending to changes in the interest rate and the sensitivity or insensitivity of money demand to changes in Y and the interest rate.

So, efficacy of fiscal policy depends on some important sensitivities!

i>clicker questionSuppose the fiscal guys decide to stimulate the economy by increasing $G. Suppose the monetary guys (Janet Yellen, inter alia) want to help out in any way they can to make the fiscal guys look good. So, they would...

A.sit on their hands and do nothing.B.buy government securities.C.sell government securities.D.decrease taxes.E.increase the discount rate.

Issue: Fed Accommodation of Fiscal Policy(of an Expansionary Fiscal Policy, in this case) An expansionary fiscal policy (higher government

spending or lower taxes) will increase aggregate output (income).

In turn, higher income will shift the money demand curve to the right, and put upward pressure on the interest rate.

If the money supply were unchanged following an increase in the demand for money, the interest rate would rise.

But if the Fed were to “accommodate” the fiscal expansion, the interest rate would not rise.

What would be true if the Fed accommodated a fiscal contraction?

G AEd Y

– MD r Id AEd Y

Y

AEd

r

M

r

Id

45° help

An INCREASE in G with Accommodation by the Fed

Policy Review Expansionary Monetary & Fiscal:

– Ms up r down Id up AEd up Y up» MD up r up Id down AEd down Y down

– G up AEd up Y up» MD up r up Id down AEd down Y down

Contractionary Monetary & Fiscal:– Ms down r up Id down AEd down Y down

» MD down r down Id up AEd up Y up

– G down AEd down Y down» MD down r down Id up AEd up Y up

The Macroeconomic Policy Mix

( Ms)

Forces push the variable in different directions. Without additionalinformation, we cannot specify which way the variable moves.

?:

Variable decreases.:

Variable increases.:

Key:

Y , r ?, I ?, CY ?, r , I , C ?Contractionary

MONETARYPOLICY

( Ms)Y?, r↓, I↑, C?Y↑, r?, I?, C↑Expansionary

Contractionary( G or T)

Expansionary( G or T)

FISCAL POLICY

The Model with the Keynesian Cross and Money Market Goods and Services Market:

– C = f(Yd) with C varying directly with Yd

» Yd = Y – Taxes Exogenous lump sum taxes Taxes = Tbar Non lump sum Taxes = Tbar + tY where t is the marginal tax rate

– Id = f(r) with Id varying indirectly with r– G is exogenous – let’s leave it that way– EX are exogenous – let’s leave them that way– IM are exogenous or some function: IM=Fbar+f(Y) or IM=Fbar+f(Yd)

PRACTICE getting all the multipliers with variations of the equations!

Money Market:– MD = f(r, Y, PL)

» with MD varying indirectly with r (a movement along)» With MD varying directly with Y and PL (a shift)

– MS if fixed by the Fed

Reminder about “sensitivities” mattering.

How Sensitivity Impacts Efficacy G AEd Y

– MD r Id AEd Y

Y

AEd

r

M

r

Id

45° help

Practice Problem Solving given A MODEL. Suppose you are given the following:C = consumption G = govern. spending MD = money demandId = investment spending T = taxes MS = money supplyY = national income/output r = interest rate Yd=disposable income

C = 600 + 0.75Yd; Id = 2000 – 1500r ; G=100; T=100; EX=0; IM=0

Money demand: MD = 900 – 1000r; The required reserve ratio for all banks in this economy is rrr=10%. No bank holds excess reserves, and everybody keeps all their money in the banking system (so no currency). The total reserves in the banking system are TR=$70.

With all that, answer the following:1. What is the total money supply? 2. What is the equilibrium interest rate? 3. What is the equilibrium level of national income?

NOW Suppose: YFE=$9,600.4. Should the FED buy or sell securities to achieve this goal? How much (give a dollar figure) should the FED buy or sell?