Principles of Economics, 6 th. Edition. N. Gregory Mankiw. Page 1. 1. Introduction
a. In this chapter we examine in more detail how the government's tools of.
Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand Principles of Economics, 8th Edition N. Gregory Mankiw Page 1 1. Introduction a. In this chapter we examine in more detail how the government’s tools of monetary and fiscal policy influence the position of the AD curve. 2. How Monetary Policy Influences Aggregate Demand a. While all three of the theories about the AD curve being negatively sloped are relevant, for the US economy the most important reason for the downward slope of the AD curve is the interest rate effect. b. The theory of liquidity preference is Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance. P. 739. i. of microeconomics and is somewhere between wrong and confusing. ii. People like Milton Friedman have maintained the essential role of microeconomics as applied to all markets. iii. Remember, money is a highly liquid asset that facilitates transactions. (1) People react to its cost, the interest rate available on other assets, and income, because it is a normal good. iv. In this analysis, there is no inflation so the nominal and real interest rates are the same. v. There is an excellent discussion of the process by which the FR increases the money supply. vi. The money supply, which is controlled by the Federal Reserve, is vertical as the Fed is not influenced by the interest rate. (1) Figure 1: Equilibrium in the Money Market. P. 740. vii. The public’s demand for money--as for all normal goods-- is negatively related to its price (the nominal rate of interest) and positively related to their nominal incomes. viii. Equilibrium in the Money Market ix. FYI: Interest Rates in the Long Run and the Short Run, P. 742. (1) This is excellent summary of the short run and long run forces in the economy. (2) In the long run: (a) Output is determined by real factors. (b) The interest rate adjusts to balance the supply and demand for loanable funds. (c) The price level adjusts to balance the supply and demand for money. (3) In the short run: (a) The price level is stuck, (b) The interest rate adjusts to balance the supply and demand for money and (c) The level of output responds to the aggregate demand for goods
Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand Principles of Economics, 8th Edition N. Gregory Mankiw Page 2 c.
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and services. The Downward Slope of the Aggregate Demand Curve i. A higher price level raises money demand, ii. The higher money demand leads to a higher interest rate and iii. The higher interest rate reduces th quantity of goods and services demanded. (1) Figure 2: The Money Market and the Slope of the AD Curve. P. 743. Changes in the Money Supply Shift the AD Curve. i. A monetary injection by the Fed increases the money supply. ii. For any given price level, a higher money supply leads to a lower interest rate, which in turn increases the quantity of goods and services demanded. iii. Figure 3: A Monetary Injection. P. 744. iv. When the Fed 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. v. Conversely, when the Fed 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. The Role of Interest-Rate Targets and Fed Policy i. Monetary policy can be described either in terms of the money supply or in terms of the interest rate. ii. The Fed can control the money supply or interest rate, but not both. iii. While the recent past has been a period of relative stability, stable interest rates tend to be pro-cyclical rather than counter-cyclical--which should be the focus of macroeconomic policy. (1) The prefer policy would cause interest rates to fall during recessions and increase during booms. The Zero Lower Bound, P. 753. i. Case Study: Why the Fed Watches the Stock Market (and Vice Versa), P. 745.
3. How Fiscal Policy Influences Aggregate Demand a. Fiscal policy refers to the government’s choices regarding the overall level of government purchases and taxes. P. 747. b. There are two macroeconomic effects that make the size of the shift in AD differ from the change in G. i. The Multiplier Effect and ii. The Crowding-out Effect c. Changes in Government Purchases Can Have a Multiplier Effect. i. This effect is too unpredictable to be used for policy purposes. (1) It is also neutralized by the following effect.
Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand Principles of Economics, 8th Edition N. Gregory Mankiw Page 3 ii.
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Multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy increase income and thereby increases consumer spending. P. 748. iii. A Formula for the Government-Purchases Multiplier (1) Multiplier = (1/(1 - MPC) (2) Figure 4: The Multiplier Effect. P. 749. iv. Other Applications of the Multiplier Effect. v. Crowding out Effect. (1) The offset in AD that results when expansionary fiscal policy raises the interest and thereby reduces investment spending. (2) This was somewhat clearer in the loanable funds market discussed in Chapter 26. (3) The multiplier effect is usually negated to some extent--if not eliminated--by the crowding out effect (4) Remember: the LRAS curve is vertical, so from a macroeconomic perspective, fiscal policy can shift output between the public and private sectors, it cannot increase it. (5) Figure 5: The Crowding Out Effect. P. 751. vi. Changes in Taxes. (1) With a temporary tax reduction, the effect on the economy is fairly small. FYI: How Fiscal Policy Might Affect Aggregate Supply, P. 752. i. If FP affects either the supply or the demand for labor, it can affect AS. ii. Supply side economists argued that the influence of tax cuts on aggregate supply is large.
4. Using Policy to Stabilize the Economy a. The Case for Active Stabilization Policy is based on Alice in Wonderland. i. The lags are too long and ii. We do not have quality data soon enough. iii. In The News: How Large is the Fiscal Policy Multipier?, P. 754. iv. Case Study: Keynesians in the White House, P. 756. (1) MIT Press published a book that contained the Economic Reports of the President from 1962 and 1982. (2) The 1962 Report is viewed as the strongest statement for Keynesian policies. (3) The 1982 Report, in which I was responsible for a chapter, is viewed as the strongest rejection of the Keynesian policies. v. Ask the Experts: Economic Stimulus, P. 756 (1) Did stimulus work in 2009? (a) 1% disagreed and (b) 99% agreed.
Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand Principles of Economics, 8th Edition N. Gregory Mankiw Page 4 (2)
The benefits of the stimulus will exceed the costs? (a) 6% disagree, (b) 19% were uncertain and (c) 75% agreed. b. The Case Against Active Stabilization Policy is based on the undisputable problems created by lags. i. A recession is two quarters of negative GDP growth and it seldom lasts more that three quarters, so you do not know you had a recession until it is almost over. ii. Even when the recession is recognized, it takes awhile for Congress and the Fed to act and then for their actions to have any effect. iii. Because of these lags, it is impossible for the government to effectively pursue an action counter-cyclical policy. c. 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. P. 758. i. The tax system and ii. unemployment compensation. 5. Conclusion 6. Summary
