Harcourt Brace & Company MONOPOLISTIC COMPETITION Chapter 17.
Harcourt Brace & Company Chapter 32 The Influence of Monetary and Fiscal Policy on Aggregate Demand.
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Transcript of Harcourt Brace & Company Chapter 32 The Influence of Monetary and Fiscal Policy on Aggregate Demand.
Harcourt Brace & Company
Chapter 32
The Influence of Monetary and Fiscal Policy on Aggregate Demand
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Economic Objectives
1. Full-N
2. Economic Growth
3. Price Stability
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Two Problems in the Economy
Inflation
Unemployment
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Inflationary Gap
Yf < Ye Normal market adjustment In the Long-run, the economy is
always at full-N
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Recessionary Gap
Ye < Yf Normal Market adjustments In the Long-run, the economy is
always at full-N
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Government Assistance
Monetary Policy Changing the Money Supply
and interest rates to achieve macroeconomic objectives by the Fed
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The Supply and Demand for Money
The Money Demand is determined mostly by the interest rate.
“People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services.” (i.e. a desire of liquidity)
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The Money MarketInterest
Rate
Quantity of Money
Money Demand
I0
Q0
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The Money MarketInterest
Rate
Quantity of Money
Money Demand
I0
I1
Q0
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The Money MarketInterest
Rate
Quantity of Money
Money Demand
I0
I1
Q1 Q0
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The Supply and Demand for Money
The Money Supply is altered in three ways by the Fed:– Open-Market Operations
– Changing the Reserve Requirements
– Changing the Discount Rate The quantity of money is fixed by the
Fed.
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The Supply and Demand for Money
Open-Market Operations can shift the Ms curve left or right.
If the Fed buys government bonds:– Bank reserves increase and the Ms
increases. If the Fed sells government bonds:
– Bank reserves decrease and the Ms decreases.
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The Money MarketInterest
Rate
Quantity of Money
Money Supply
QFixed
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The Money MarketInterest
Rate
Quantity of Money
Money Supply
QFixed
If the Fed buys government
bonds, money supply
increases.
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The Money MarketInterest
Rate
Quantity of Money
Money Supply
QFixed
If the Fed sells government
bonds, money supply
decreases.
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Equilibrium in the Money Market
By the Theory of Liquidity Preference:– The interest rate adjusts to balance the
supply and demand for money.
– There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded exactly equals the quantity of money supplied.
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Equilibrium in the Money MarketInterest
Rate
Quantity of Money
Money Demand
Money Supply
QFixed
IE
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Equilibrium in the Money MarketInterest
Rate
Quantity of Money
Money Demand
Money Supply
QFixed
IE
Money Supply andMoney Demand are
equal at the equilibriuminterest rate.
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Changes in Money SupplyInterest
Rate
Quantity of Money
Money Demand
MS0
QFixed0
IE0
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Changes in Money SupplyInterest
Rate
Quantity of Money
Money Demand
MS0
QFixed0
IE0
MS1
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Changes in Money SupplyInterest
Rate
Quantity of Money
Money Demand
MS0
QFixed0
IE0
MS1
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Changes in Money SupplyInterest
Rate
Quantity of Money
Money Demand
MS0
QFixed0
IE0
IE1
QFixed1
MS1
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Closing an Inflationary Gapusing Monetary Policy
Ms falls, interest rates rise, and AD falls
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Closing a Recessionary Gap using Monetary Policy
Ms rises, interest rate falls and AD rises
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Discretionary Fiscal Policy
Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes to achieve macroeconomic objectives.
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Using Policy to Stabilize the Economy
Those that accept discretionary fiscal policy as a means to attain short-run economic stabilization follow the Keynesian theory of the economy.
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Federal Government Budget
The Federal government has the largest budget in the world - $1.7 billion.
General Motors, the largest corporation, has $165 billion.
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Changes in Government Purchases
The federal government’s control of the economy is both direct and indirect.– Its expenditures have a direct effect on
aggregate spending and therefore equilibrium GDP.
– Taxes and tax policy indirectly affect the aggregate spending of consumers.
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Closing an Inflationary Gap using Fiscal Policy
Government spending falls and/or taxes rise and AD falls.
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Closing a Recessionary Gap using Fiscal Policy
Government spending rises and/or taxes fall and AD rises.
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Changes in Government Purchases
There are two macroeconomic effects from government purchases:
– The Multiplier Effect
– The Crowding-Out Effect
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The Multiplier Effect of Government Purchases
Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar--- a multiplier effect.
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The Multiplier EffectPriceLevel
Quantity of Output
AD1
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The Multiplier EffectPriceLevel
Quantity of Output
AD1 AD2
An increase in government
purchases initially increases AD
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The Multiplier EffectPriceLevel
Quantity of Output
AD1 AD2
The multiplier effect can amplify the shift
in AD
AD3
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The Multiplier Effect of Government Purchases
The formula for the multiplier is:
Multiplier = 1 ÷ (1 - MPC) the MPC is the Marginal Propensity to Consume.
MPC - how much of each additional dollar of income a household spends
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The Crowding-Out Effect
An increase in government purchases causes the interest rate to rise, and a higher interest rate tends to choke off the demand for goods and services.
The reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.
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Using Policy to Stabilize the Economy
Some economists argue that the government should avoid using monetary and fiscal policy to try to stabilize the economy. They suggest the economy should be left to deal with the short-run fluctuations on its own.
Discretionary Fiscal policy affects the economy with substantial lags.
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Automatic Stabilizers
Automatic Stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.
Automatic stabilizes include:– The Tax System
– Government Spending