Chapter 20 The Influence of Monetary and Fiscal Policy on Aggregate Demand

1. Chapter 20 The Influence of Monetary and Fiscal Policy on Aggregate Demand • How Monetary Policy Influences Aggregate Demand • How Fiscal Policy Influences Aggregate Demand • Using Policy to Stabilize the Economy

2. In this chapter, we will see how the tools of monetary and fiscal policy can shift the aggregate-demand curve and, in doing so, affect short-run economic fluctuations. • Many factors influence AD, including desired spending by households and business firms. When desired spending changes, shifts in the AD cause short-run fluctuations in output and employment. • Monetary and Fiscal policy are used to stabilize the economy during these fluctuations. • The Aggregate Demand curve is downward sloping due to three effects: ( See Chapter 19) • Pigou’s Wealth Effect • Keynes’s Interest-Rate Effect • Real Exchange-Rate Effect • Of these three effects, the Keynes’s Interest-Rate Effect is most important.

3. Theory of Liquidity Preference: Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance. • In this chapter, we assume the expected rate of inflation is constant in the short run. So, when the nominal interest rate rises or falls, the real interest rate that people expect to earn rises or falls as well. The real and nominal interest rate move in the same direction. • The Money Supply is controlled by the B of C, which alters the money supply in three ways: • Open-Market Operations • Changing the Bank Rate • Buying and selling Canadian dollars in the market for foreign-currency exchange • The quantity of money supplied in the economy is fixed at whatever level the B of C decides to set it.

4. Because the money supply is fixed by the B of C it does not depend on the interest rate. • The fixed money supply is represented by a vertical supply curve. See Figure 20-1. • By using the Open-Market Operations the B of C can shift the vertical money supply curve left or right. • If the B of C buys government bonds: • Bank reserves increase and the money supply increases. • If the B of C sells government bonds: • Bank reserves decrease and the money supply declines. • The Money Demand is determined by several factors. However, the most important is 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)

5. Asset’s liquidity refers to the ease with which that asset is converted into the economy’s medium of exchange. • The primary opportunity cost of having the convenience of holding money is the interest income that one gives up when one holds cash or chequing account balances. • An increase in the interest rate raises the cost of holding money and thus reduces the quantity of money balances people wish to hold. See Figure20-2. • Shift in the demand for money: See Figure 20-3 • Shift the demand to the right if the dollar value of transactions increases because of an increase in either prices or GDP for any interest rate. • Shift the demand to the left if the dollar value of transactions decreases because of an decrease in either prices or GDP for any interest rate.

6. 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. • See Figure 20-4. If the interest rate is above the equilibrium level (such as at r1), the quantity of money people want to hold is less than the quantity the Bank of Canada has created, and this surplus of money puts downward pressure on the interest rate. • Conversely, if the interest rate is below the equilibrium level (such as at r2), the quantity of money people want to hold is more than the quantity the Bank of Canada has created, and this shortage of money puts upward pressure on the interest rate.

7. Thus, the forces of supply and demand in the market for money push the interest rate toward the equilibrium interest rate. Use the Theory of Liquidity Preference to reexamine the interest rate effect and the downward slope of Aggregate Demand Curve • We know the price level is one determinant of the quantity of money demanded. • A higher price level raises money demand (i.e. a shift in the money demand curve.) • Higher money demand leads to a higher interest rate. • Higher interest rates reduces the quantity of goods and services demanded (AD). • See Figure 20-5.

8. As interest rates increase, the cost of borrowing and the return to saving is greater. Fewer households and firms borrow money, leading to a decrease in spending. • An increase in the price level causes the real exchange rate to increase and net exports to fall. • The end result is a negative relationship between the price level and the AD.

9. Change in the money supply in a closed economy • The B of C has control over shifts in the aggregate demand when it changes monetary policy. Recall: ( Figure 16-2) An increase in the money supply (i.e. buying bonds) will...shift the Money Supply to the right…without a change in the Money Demand the interest rate will fall, thus… inducing people to hold the additional money the B of C has created. • See Figure 20-6 • To sum up: when the Bank of Canada increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting the AD curve to the right. Conversely, when the Bank of Canada contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded for any given price level, shifting the AD curve to the left.

10. Open-Economy Considerations • Our discussion of how monetary policy affects AD so far has ignored open-economy considerations. • Recall in a small closed economy model: • A monetary injection by the B of C causes interest rates to fall, leading to a stimulative effect on residential and firm investment, and increasing output. • The increase in output requires that people hold more money. This raises the demand curve for money and causes a partial reversal in the interest rate. • As a result, the increase in the quantity of goods and services is smaller that it would have otherwise been. • Now, assume Canada’s interest rate should equal to the world interest rate. ( Interest rate parity, Ch 17)

11. See Figure 20-7, a monetary injection in an open economy • Monetary injection by the B of C causes the dollar to depreciate, which causes net exports to rise shifting the AD curve to the right. Output increases by more than it would in a closed economy. • The B of C must allow the exchange rate to vary freely if its desire is to change the money supply. • To sum up: In a small open economy, a monetary injection by the Bank of Canada causes the dollar to depreciate in value. Because this depreciation of the dollar causes net exports to rise, there is an additional increase in demand for Canadian-produced goods and services that is not realized in a closed economy. In the end, a monetary injection in an open economy shifts the AD curve farther to the right than it does in a closed economy.

12. The effects of a monetary injection: Summary • See Table 20-1.

13. How Fiscal Policy Influences AD • The federal government can influence the behaviour of the economy not only with monetary policy but also with fiscal policy. • Fiscal policy refers to the federal government’s choices regarding the overall level of government purchases or taxes. • The federal government can influence the economy because • of the size of the central government in relation to the economy and other economic entities. • of the deliberate use of spending and taxes to manipulate the economy toward achieving a predetermined outcome. • 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.

14. Taxes and tax policy indirectly affect the aggregate spending of consumers. • There are two macroeconomic effects from government purchases: • The Multiplier Effect • The Crowding-Out Effect • 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. • The total impact of the quantity of goods and services demanded can be much larger than the initial impulse from higher government spending. • See Figure 20-8

15. The formula for the multiplier in a closed economy is: • Multiplier = 1 ÷ (1 - MPC) • the MPC is the Marginal Propensity to Consume. • In an open economy : • Multiplier = 1 ÷ (1 – MPC+MPI) • The MPI is the Marginal Propensity to Import. • See Lipsey/Regan’s example on page 571/572 of Lipsey/Regan Macroeconomics 11th edition. (Publisher: Pearson Addison Wesley)

16. 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. • See Figure 20-9 To sum up: • When the government increases its purchases by $ 5 billion, the AD for goods and services could raise by more or less than $5 billion, depending on whether the multiplier effect or the crowding-out effect on investment is larger.

17. A Fiscal expansion in an open economy • In a closed economy, an increase in G causes the interest rate to rise and output to increase. • In a small, open economy, the fact that the domestic interest rate, r2 is greater than the world interest rate, rw, means there must be further adjustment. Canadian and foreign savers find the Canadian interest rate more attractive than the world interest rate. As a result, they buy Canadian assets and sell foreign assets. The Canadian dollars appreciate. • See Figure 20-10. Fiscal expansion in an open economy • With flexible exchange rate • Crowding-out effect on net exports: the offset in AD that results when expansionary fiscal policy in a small open economy with a flexible exchange rate raises the real exchange rate and thereby reduces net exports.

18. To sum up: In a small, open economy, an expansionary fiscal policy causes the dollar to appreciate. Since this causes net exports to fall, there is an additional crowding-out effect that reduces the demand for Canadian produced goods and services. In the end, fiscal policy has no lasting effect on AD. • See Figure 20-11. Fiscal expansion in an open economy • With fixed exchange rate • To sum up: If the B of C chooses to prevent any change in the exchange rate, an expansionary fiscal policy will have no crowding-out effect and will therefore cause a very large increase in the demand for goods and services. The coordination of Monetary and Fiscal Policy • For fiscal policy to have a lasting effect on the position of the AD curve, the Bank of Canada must choose the appropriate exchange rate policy.

19. However, fiscal policy decisions are made by Parliament and by provincial legislatures while monetary policy is determined by the Bank of Canada. • Such coordination has not always been observed. (Read by yourself) • See Table 20-2. The effects of Fiscal Policy: Summary Changes in Taxes • When the government cuts taxes, it: • Increases households’ take-home pay, which ...results in households saving some of the additional income, but … households will spend some on consumer goods, thus … shifting the aggregate-demand curve to the right. • The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier and crowding-out effects.

20. The duration of the shift in the aggregate demand is also determined by the B of C’s policy for the exchange rate (fixed or varied). Deficit Reduction • Canadian governments at both the federal and the provincial levels have taken steps to reduce or eliminate their budget deficits. Some governments have relied primarily on reductions in expenditures, others have relied primarily on tax increases, and others have relied on a combination of both approaches. • As long as the B of C chooses to allow the exchange rate to vary freely, there is no reason to expect that efforts at deficit reduction will have any lasting influence on the position of the AD curve.

21. Using Policy to Stabilize the Economy 1, The case for active stabilization policy • If monetary and fiscal policy can be used to stabilize the economy, then surely these tools should be used to offset the harmful effects of economic fluctuations. • John Keynes in his book, the general theory of employment,Interest and Money, emphasized the key role of AD in explaining short-run economic fluctuations. Keynes claimed that the government should actively stimulate AD when AD appeared insufficient to maintain production at its full-employment level. • Keynes( and his many followers) was a strong advocate of using policy instruments to stabilize the economy.

22. 2, The case against active stabilization policy • The primary argument against active monetary and fiscal policy is that these policies affect the economy with a substantial lag. Most economists believe that it takes at least six months for changes in monetary policy to have much effect on output and employment. • Critics of stabilization policy argue that because of this lag, the B of C should not try to fine-tune the economy. They claim that the B of C often reacts too late to changing economic conditions and as a result, ends up being a cause of rather than a cure for economic fluctuations.

23. 3, All economists-both advocates and critics of stabilization policy-agree that the lags in implementation render policy less useful as a tool for short-run stabilization. • Automatic Stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policy-makers having to take any deliberate action. • Automatic stabilizers include: • The Tax System: the most important one; Ex: The automatic tax cut in a recession stimulates AD and thereby, reduces the magnitude of economic fluctuations. • Government Spending • Flexible Exchange Rate • However, when the economy goes into a recession, taxes fall, government spending rises, and the government’s budget moves toward deficit.

24. If the government faced a strict balanced-budget rule, it would be forced to look for ways to raise taxes or cut spending in a recession. In other words, a strict balanced-budget rule would eliminate the automatic stabilizers inherent in our current system of taxes and government spending. A flexible exchange rate as an automatic stabilizer • Suppose Canada’s largest trading partner, USA, slips into recession. • As the incomes of American households and firms fall, they spend less and we can expect that they buy fewer Canadian-produced goods. • Canada’s net exports fall and the AD shifts to the left.

25. If the B of C has chosen to allow the exchange rate to be flexible, we could expect the following to occur: • The fall in net exports causes the incomes of Canadians to fall, and this reduces the demand of money. This causes Canada’s interest rate to fall below the world interest rate. • Both Canadians and foreigners sell Canadian assets in favour of foreign assets that pay the higher world interest rate. • The switch from Canadian to foreign assets requires a corresponding sale of dollars in the market for foreign-currency exchange. • The increased supply of Canadian dollars in the market causes the exchange rate to depreciate, and this causes net exports to increase.

26. Canada’s AD shifts back to the right, increasing the incomes of Canadians and increasing the demand for money until Canada’s interest rate is again equal to the world interest rate. • The recession in the USA has no lasting effects on the position of Canada’s AD curve. The effects of expansionary monetary and fiscal policies on the AD curve (See Figure 20-12) • How fiscal and monetary policy affect the position of the AD curve depends on whether the economy is closed or open. • If the economy is open, the effect of fiscal and monetary policy depends on whether the B of C chooses to fix the value of exchange rate or allow it to be flexible.

27. Conclusion • Government macroeconomic policy should proceed carefully and with an understanding of the consequences of its policies in the short and long-run. • Fiscal policies can have long-run effects on saving, investment, the trade balance and growth. • Monetary policy can ultimately determine the level of prices and affect the inflation rate.