The Influence of Monetary and

21 Fiscal Policy on Aggregate Demand

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 1.Interest Rate in the Long-run and Short-run
-. Loanable Funds Market vs Liquidity Preference
Theory(LPT)
2. LPT and interest rate
3. Monetary Policy and AD
-. FED and Stock Market (AD)
% L-R: P is neutral, S-R: P changes AD/Y.

4. Fiscal Policy and AD

-. Multiplier, Crowding out and Tax
5. Fiscal Policy and AS: “supply-siders”
6. Stabilization Policy
-. Activist, Opponents
-. Automatic Stabilizers
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 1
In this chapter, look for the answers to
these questions:
(1). How does the interest-rate effect help explain
the slope of the AD curve?
(2). How can the central bank use monetary policy
to shift the AD curve?
(3). In what two ways does fiscal policy affect AD?
(4). What are the arguments for and against using
policy to try to stabilize the economy?

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 2

 0. Introduction
(1). Earlier chapters covered:
• the long-run effects of fiscal policy
on interest rates, investment, economic growth
• the long-run effects of monetary policy
on the price level and inflation rate
(2).This chapter focuses on the short-run effects
of fiscal and monetary policy,
which work through AD.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 3

 1. Aggregate Demand
 Recall, the AD curve slopes downward for three
reasons:
• the wealth effect the most important
• the interest-rate effect of these effects for
• the exchange-rate effect the U.S. economy

 Next: a supply-demand model that helps

explain the interest-rate effect and how
monetary policy affects AD.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 4

 2.A. Interest rate in the L-R and S-R
 LR: Loanable Funds  SR: Liquidity
Market (real) Preference theory
(1). Y (Output ) is determined by supplies (1). Price is stuck at previous
of L, P, H, L, R, T expectation (PE)and unresponsive to
changing economic conditions.
(2).Given Y, interest rate adjusts to
balance S & D for loanable funds. (2). Given (stuck) P, interest rate
adjusts to balance Md and Ms
(3). Given Y, r, the Price adjusts to
d s
(Money Market)
balance the M and M (Money
Market) (3). Interest rate that balances the
money market influences AD and the
(i.e., change in Ms cause proportional
Y.
change in Price level).
M s changes i (INV, AD) and Y
Ms changes prices (P) and neutral for Y.
adjustment b/w short-run and long-
run: y<yn, P decrease, y>yn price
increase
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 5
2. The Theory of Liquidity Preference
 A simple theory of the interest rate (denoted r)
 r adjusts to balance supply and demand
for money
 Money supply: assume fixed by central bank,
does not depend on interest rate

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 6

2.The Theory of Liquidity Preference
 Money demand reflects how much wealth
people want to hold in liquid form.
 For simplicity, suppose household wealth
includes only two assets:
• Money – liquid but pays no interest
• Bonds – pay interest but not as liquid
 A household’s “money demand” reflects its
preference for liquidity.
 The variables that influence money demand:
Y, r, and P.
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 7
1. According to liquidity preference theory, an
increase in money demand for some reason
other than a change in the price level causes
a. the interest rate to fall, so aggregate demand shifts right.

b. the interest rate to fall, so aggregate demand shifts left.

c. the interest rate to rise, so aggregate demand shifts right.

d. the interest rate to rise, so aggregate demand shifts left.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 8

 2.1. Money Demand
 Suppose real income (Y) rises. Other things equal,
what happens to money demand?
 MD = F(Y, P, r) : F’(Y)>0, F’(P)>0, F’(r)<0.
 If Y rises:
• Households want to buy more g&s,
so they need more money.
• To get this money, they attempt to sell some of
their bonds.
 I.e., an increase in Y causes
an increase in money demand, other things equal.
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 9
ACTIVE LEARNING 1:
The determinants of money demand
A. Suppose r rises, but Y and P are unchanged.
What happens to money demand?
B. Suppose P rises, but Y and r are unchanged.
What happens to money demand?

10
ACTIVE LEARNING 1:
Answers
A. Suppose r rises, but Y and P are unchanged.
What happens to money demand?
r is the opportunity cost of holding money.
An increase in r reduces money demand:
Households attempt to buy bonds to take
advantage of the higher interest rate.
Hence, an increase in r causes a decrease in
money demand, other things equal.

11
ACTIVE LEARNING 1:
Answers
B. Suppose P rises, but Y and r are unchanged.
What happens to money demand?
If Y is unchanged, people will want to buy the
same amount of g&s.
Since P is higher, they will need more money
to do so.
Hence, an increase in P causes an increase
in money demand, other things equal.

12
 2.2. How r Is Determined

Interest MS curve is vertical:

rate MS
Changes in r do not
affect MS, which is
r1 fixed by the Fed.
Eq’m MD curve is
interest downward sloping:
rate MD1 a fall in r increases
money demand.
M
Quantity fixed
by the Fed
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 13
Figure 1
Equilibrium in the Money Market: liquidity preference
the interest rate adjusts to
theory bring the quantity of money
Interest supplied and the quantity of
Money supply
rate money demanded into
balance.
If the interest rate is above
the equilibrium level (such
r1 as at r1), the quantity of
Equilibrium money people want to hold
Interest rate (Md1) is less than the
quantity the Fed has created,
r2
and this surplus of money
puts downward pressure on
the interest rate.
Money
demand
Md1 Quantity Md2 Quantity of Money
Fixed by the Fed
Conversely, if the interest rate is below the equilibrium level (such as at r2), the quantity of money people
want to hold (Md2) is greater than the quantity the Fed has created, and this shortage of money puts
upward pressure on the interest rate. Thus, the forces of supply and demand in the market for
money push the interest rate toward the equilibrium interest rate, at which people are content holding
the quantity of money the Fed has created.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 14
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 2.3. How the Interest-Rate Effect Works
A fall in P reduces money demand, which lowers r.
Interest P
rate MS

r1
P1

r2 P2
MD1 AD
MD2
M Y1 Y2 Y

A fall in r increases I and the quantity of g&s

demanded. Y Increase.
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 15
Figure 2
Increase in P money demand, which increase r, decrease Y
(a) The Money Market (b) The Aggregate-Demand Curve
Interest Price
rate Money 2. . . . increases the level 1. An increase in the price level . . .
supply demand for money . . .
4. . . . which in turn
3. . . . which increases reduces the quantity
equilibrium interest rate . . . P of goods and
r2 2 services demanded.

r1 Money demand at
price level P2, MD2 P1

Money demand at Aggregate

price level P1, MD1 demand

0 Quantity fixed Quantity 0 Y2 Y1 Quantity

by the Fed of money of output
An increase in the price level from P1 to P2 shifts the money-demand curve to the right, as in
panel (a). This increase in money demand causes the interest rate to rise from r1 to r2. Because
the interest rate is the cost of borrowing, the increase in the interest rate reduces the
quantity of goods and services demanded from Y 1 to Y2. This negative relationship between the
price level and quantity demanded is represented with a downward-sloping aggregate-demand
curve, as in panel (b).
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 16
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2. Assume the money market is always in equilibrium, and
suppose r1 = 0.08; r2 = 0.12; Y1 = 13,000; Y2 = 10,000; P1 =
1.0; and P2 = 1.2. Which of the following statements is correct?
On the left-hand graph,
MS MS represents the
supply of money and
MD represents the
r2
P2 demand for money; on
r1
P1 the right-hand graph,
MD
2 AD represents
AD
aggregate demand. The
MD
1 usual quantities are
measured along the
Y2 Y1 axes of both graphs.
a. When r = r2, nominal output is higher than it is when r = r1.
b. When r = r2, real output is higher than it is when r = r1.
c. When r = r2, the expected rate of inflation is higher than it is when r = r1.
d. If the velocity of money is 4 when r = r2, then the quantity of money is
$3,000.
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 17
Monetary Tightening & Interest Rates, cont.
The effects of a monetary tightening
on nominal interest rates
short run long run
(M/P down, i high) (E down, i down)
Quantity theory,
model liquidity preference
Fisher effect
(Keynesian)
(Classical)

prices sticky flexible

prediction i > 0 i < 0

actual 8/1979: i = 10.4% 8/1979: i = 10.4%

outcome 4/1980: i = 15.8% 1/1983: i = 8.2%
18
 1.Interest Rate in the Long-run and Short-run
-. Loanable Funds Market vs Liquidity Preference
Theory(LPT)
2. LPT and interest rate
3. Monetary Policy and AD
-. FED and Stock Market (AD)
% L-R: P is neutral, S-R: P changes AD/Y.

4. Fiscal Policy and AD

-. Multiplier, Crowding out and Tax
5. Fiscal Policy and AS: “supply-siders”
6. Stabilization Policy
-. Activist, Opponents
-. Automatic Stabilizers
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 19
3. Monetary Policy and Aggregate Demand
 To achieve macroeconomic goals, the Fed can
use monetary policy to shift the AD curve.
 The Fed’s policy instrument is the money supply.
 The news often reports that the Fed targets the
interest rate.
• more precisely, the federal funds rate – which
banks charge each other on short-term loans
 To change the interest rate and shift the AD
curve, the Fed conducts open market
operations
to change the money supply.
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 20
 3.1. The Effects of Reducing the Money
Supply
The Fed can raise r by reducing the money supply.
Interest P
rate MS2 MS1

r2
P1
r1
AD1
MD AD2
M Y2 Y1 Y

An increase in r reduces the quantity of g&s demanded.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 21
*3. If money demand shifted to the right and
the Federal Reserve desired to return the
interest rate to its original value, it could
a. buy bonds to increase the money supply.

b. buy bonds to decrease the money supply.

c. sell bonds to increase the money supply.

d. sell bonds to decrease the money supply.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 22

Figure 3
A Monetary Injection
Interest (a) The Money Market Price (b) The Aggregate-Demand Curve
rate level
Money supply,
MS1 MS2
1. When the Fed
increases the
r1 money supply . . .
P

r2

AD2
Money demand Aggregate
at price level P demand, AD1
0 Quantity 0 Y1 Y2 Quantity of output
2. . . . the equilibrium of money 3. . . . which increases the quantity of goods
interest rate falls . . . and services demanded at a given price level.
In panel (a), an increase in the money supply from MS 1 to MS2 reduces the equilibrium interest
rate from r1 to r2. Because the interest rate is the cost of borrowing, the fall in the interest rate
raises the quantity of goods and services demanded at a given price level from Y 1 to Y2. Thus,
in panel (b), the aggregate-demand curve shifts to the right from AD1 to AD2.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 23
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4. If the Fed conducts open-market sales,
which of the following quantities increase(s)?
a. interest rates, prices, and investment spending

b. interest rates and prices, but not investment spending

c. interest rates and investment, but not prices

d. interest rates, but not investment or prices

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 24

ACTIVE LEARNING 2:
Exercise
For each of the events below,
(1). determine the short-run effects on output
(2). determine how the Fed should adjust the
money supply and interest rates to stabilize
output
A. Congress tries to balance the budget by cutting
govt spending.
B. A stock market boom increases household
wealth.
C. War breaks out in the Middle East,
25
causing oil prices to soar.
ACTIVE LEARNING 2:
Answers
A. Congress tries to balance the budget by
cutting govt spending.
This event would reduce agg demand and
output.
To offset this event, the Fed should increase
MS and reduce r to increase agg demand.

26
ACTIVE LEARNING 2:
Answers
B. A stock market boom increases household
wealth.
This event would increase agg demand,
raising output above its natural rate.
To offset this event, the Fed should reduce MS
and increase r to reduce agg demand.

27
ACTIVE LEARNING 2:
Answers
C. War breaks out in the Middle East,
causing oil prices to soar.
This event would reduce agg supply,
causing output to fall.
To offset this event, the Fed should increase
MS and reduce r to increase agg demand.

28
5. Changes in the interest rate
a. shift aggregate demand whether they are caused by changes in the
price level or by changes in fiscal or monetary policy.

b. shift aggregate demand if they are caused by changes in the price

level, but not if they are caused by changes in fiscal or monetary policy.

c. shift aggregate demand if they are caused by fiscal or monetary policy,

but not if they are caused by changes in the price level.

d. do not shift aggregate demand.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 29

 Why the Fed Watches the Stock Market
(and Vice Versa)
(1). Fluctuations in stock prices
– Sign of broader economic developments
– Economic boom of the 1990s
• Rapid GDP growth and falling unemployment
• Rising stock prices (fourfold)
– Deep recession of 2008 and 2009
• Falling stock prices
– From November 2007 to March 2009, the stock
market lost about half its value

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 30
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Why the Fed Watches the Stock Market
(and Vice Versa)
(2). The Fed
– Not interested in stock prices themselves
– Monitor and respond to developments the
overall economy
• Stock market boom expands the AD
– Households – wealthier
• Stimulates consumer spending
– Firms – want to sell new shares of stock
• Stimulates investment spending

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 31
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Why the Fed Watches the Stock Market
(and Vice Versa)
(3). The Fed’s goal: stabilize AD
– Greater stability in output and price
level
a. The Fed’s response to a stock-market
boom
– Keep money supply lower
– Keep interest rates higher
b. The Fed’s response to a stock-market fall
– Increase money supply
– Lower interest rates
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 32
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Why the Fed Watches the Stock Market
(and Vice Versa)
(4). Stock-market participants
– Keep an eye on the Fed
– The Fed can
• Influence interest rates and economic activity
• Alter the value of stocks
(5). The Fed - raises interest rates
– Less attractive owning stocks
• Bonds - earning a higher return
• Reduced demand for goods and services

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 33
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The Zero Lower Bound
FED: (Def) If i=zero (=liquidity trap).
(1). Forward Guidance: commit itself to keep i
low for extended period of time.
-. May help stimulate investment spending.
(2). QE(Quantitative Easing):OMO with long-
term T-bond, corporate debt, buy mortgages &
lower the i on those.
-. bank reserves(+): more liquidity.
-. Zero Bound justifies target inflation above
zero. Real i=Negative. Reduce the risk of
liquidity trap.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 34
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 John Maynard Keynes, 1883-1946

• The General Theory of Employment,

Interest, and Money, 1936
• Argued recessions and depressions
can result from inadequate demand;
policymakers should shift AD.
• Famous critique of classical theory:
The long run is a misleading
guide to current affairs. In the long
run, we are all [ Economists
]. set themselves
too easy, too useless a task if in tempestuous seasons
they can only tell us when the storm is long past,
the ocean will be flat.
1.Interest Rate in the Long-run and Short-run
-. Loanable Funds Market vs Liquidity Preference
Theory(LPT)
2. LPT and interest rate
3. Monetary Policy and AD
-. FED and Stock Market (AD)
% L-R: P is neutral, S-R: P changes AD/Y.

4. Fiscal Policy and AD

-. Multiplier, Crowding out and Tax
5. Fiscal Policy and AS: “supply-siders”
6. Stabilization Policy
-. Activist, Opponents
-. Automatic Stabilizers
CHA
 4. Fiscal Policy and Aggregate Demand

 Fiscal policy: the setting of the level of govt.

spending and taxation by govt policymakers
 Expansionary fiscal policy
• an increase in G and/or decrease in T
• shifts AD right
 Contractionary fiscal policy
• a decrease in G and/or increase in T
• shifts AD left
 Fiscal policy has two effects on AD.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 37

 4.1. The Multiplier Effect
 If the govt buys $20b of planes from Boeing,
Boeing’s revenue increases by $20b.
 This is distributed to Boeing’s workers (as wages)
and owners (as profits or stock dividends).
 These people are also consumers, and will spend
a portion of the extra income.
 This extra consumption causes further increases
in aggregate demand.
Multiplier effect: the additional shifts in AD
that result when fiscal policy increases income
and thereby increases consumer spending
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 38
 4.1.The Multiplier Effect

A $20b increase in G P
initially shifts AD
to the right by $20b.
AD2 AD3
The increase in Y AD1
causes C to rise,
P1
which shifts AD
further to the right. $20 billion

Y1 Y2 Y3 Y

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 39

4.1. Marginal Propensity to Consume
 How big is the multiplier effect?
It depends on how much consumers respond to
increases in income.
 Marginal propensity to consume (MPC):
the fraction of extra income that households
consume rather than save
 E.g., if MPC = 0.8 and income rises $100,
C rises $80.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 40

 4.1.1. A Formula for the Multiplier
Notation: G is the change in G,
Y and C are the ultimate changes in Y and C
Y = C + I + G + NX identity

Y = C + G I and NX do not change

Y = MPC Y + G because C = MPC Y

1
Y = G solved for Y
1 – MPC

The multiplier

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 41

 4.1.1. A Formula for the Multiplier
The size of the multiplier depends on MPC.
e.g., if MPC = 0.5 multiplier = 2
if MPC = 0.75 multiplier = 4
if MPC = 0.9 multiplier = 10

A bigger MPC means

1 changes in Y cause
Y = G
1 – MPC bigger changes in C,
which in turn cause
The multiplier more changes in Y.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 42

 4.1.2 Tax Multiplier
Notation: T is the change in T,
Y and C are the ultimate changes in Y and C
Y = C (DI=Y-T) + I + G + NX identity

Y = C I and NX do not change

Y = MPC (Y -T) C = MPC (Y - T)

-MPC
Y = T solved for Y
1 – MPC

The Tax
multiplier
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 43
*4.1.Other Applications of the Multiplier Effect
 The multiplier effect:
each $1 increase in G can generate
more than a $1 increase in agg demand.
 Also true for the other components of GDP.
Example: Suppose a recession overseas
reduces demand for U.S. net exports by $10b.
Initially, agg demand falls by $10b.
The fall in Y causes C to fall, which further
reduces agg demand and income.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 44

*4.1.Other Applications of the Multiplier Effect
-. The Size of Multiplier:
near Full employment: close to zero
In recession: well above 1
-. Temporary vs permanent tax cut
-. Heavily indebted countries vs prudent country.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 45

6. In a certain economy, when income is $400, consumer
spending is $350. The value of the multiplier for this
economy is 3.125. It follows that, when income is $450,
consumer spending is

a. $384. For this economy, an initial impulse of $50 in consumer spending

translates into a $146.67 increase in aggregate demand.

b. $384. For this economy, an initial impulse of $50 in consumer spending

translates into a $156.25 increase in aggregate demand.

c. $389.38. For this economy, an initial impulse of $50 in consumer

spending translates into a $146.67 increase in aggregate demand.

d. $389.38. For this economy, an initial impulse of $50 in consumer

spending translates into a $156.25 increase in aggregate demand.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 46

 4.2. The Crowding-Out Effect
(1). Fiscal policy has another effect on AD
that works in the opposite direction.
(2). A fiscal expansion shifts AD to the right,
but also raises i (why?, Y is higher and
increase M demand),
which reduces investment and, thus,
reduces the net increase in agg demand.
(3). So, the size of the AD shift may be smaller
than the initial fiscal expansion.
(4). This is called the crowding-out effect.
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 47
 4.2. How the Crowding-Out Effect
Works
A $20b increase in G initially shifts total AD right by $100b
Interest P
rate MS

AD AD2
r2 AD1 3

P1
r1
MD2 $100 billion

MD1
M Y1 Y3 Y2 Y

But higher Y increases MD and r, which reduces AD.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 48
*7. Suppose the multiplier is 5 and the government increases its purchases
by $10 billion. Also, suppose the AD curve would shift from AD1 to AD2 if
there were no crowding out; the AD curve actually shifts from AD1 to AD3 with
crowding out. Also, suppose the horizontal distance between the curves AD1
and AD3 is $20 billion. The extent of crowding out, for any particular level of
the price level, is
P
MS

r2

r1 MD AD
2 2
AD
3
MD AD 1
1

Y
On the left-hand graph, MS represents the supply of money and MD represents the demand for money; on the right-hand
graph, AD represents aggregate demand. The usual quantities are measured along the axes of both graphs.

a. the horizontal distance between the curves MD1 and MD2.

b. $40 billion.
c. $30 billion.
d. $20 billion.
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 49
*8. In 2009 President Obama and Congress
increased government spending. Some
economists thought this increase would have little
effect on output. Which of the following would make
the effect of an increase in government expenditures
on aggregate demand smaller?
a. the MPC is small and changes in the interest rate have a small effect on
investment
b. MPC is small and changes in the interest rate have a large effect on
investment
c. the MPC is large and changes in the interest rate have a small effect on
investment
d. the MPC is large and changes in the interest rate have a large effect on
investment

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 50

 4.3. Changes in Taxes
(1). A tax cut increases households’ take-home
pay. Households respond by spending a portion of
this extra income, shifting AD to the right.
(2). The size of the shift is affected by the
multiplier and crowding-out effects.
(3). Another factor: whether households perceive
the tax cut to be temporary or permanent.
• A permanent tax cut causes a bigger
increase in C – and a bigger shift in the AD
curve – than a temporary tax cut.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 51

9. The government increases both its expenditures
and taxes by $400 billion. There is no crowding out
and no accelerator effect. Aggregate demand shifts
by $400 billion. Which of the following is consistent
with how far aggregate demand shifts?
a. MPC = 1/2, and the effects of the increase in taxes is 1/2 as strong as
the change in government expenditures.

b. MPC = 2/3, and the effects of the increase in taxes is 2/3 as strong as
the change in government expenditures

c. MPC = 3/4, and the effects of the increase in taxes is 3/4 as strong as
the change in government expenditures

d. All of the above are correct.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 52

ACTIVE LEARNING 3:
Exercise
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
B. If there is crowding out, will Congress need to
increase G more or less than this amount?

53
ACTIVE LEARNING 3:
Answers
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
Multiplier = 1/(1 – .8) = 5
Increase G by $40b
to shift agg demand by 5 x $40b = $200b.

54
ACTIVE LEARNING 3:
Answers
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
B. If there is crowding out, will Congress need to
increase G more or less than this amount?
Crowding out reduces the impact of G on AD.
To offset this, Congress should increase G by
a larger amount.

55
 1.Interest Rate in the Long-run and Short-run
-. Loanable Funds Market vs Liquidity Preference
Theory(LPT)
2. LPT and interest rate
3. Monetary Policy and AD
-. FED and Stock Market (AD)
% L-R: P is neutral, S-R: P changes AD/Y.

4. Fiscal Policy and AD

-. Multiplier, Crowding out and Tax
5. Fiscal Policy and AS: “supply-siders”
6. Stabilization Policy
-. Activist, Opponents
-. Automatic Stabilizers
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 56
5. Fiscal Policy and Aggregate Supply
<Supply-siders>

(1). Most economists believe the short-run

effects of fiscal policy mainly work through AD.
(2). But fiscal policy might also affect AS.
(3). A cut in the tax rate gives workers incentive
to work more, so it might increase the quantity
of g&s supplied and shift AS to the right.
--. People who believe this effect is large are
called “Supply-siders.”

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 57

5. Fiscal Policy and Aggregate Supply

(4). Suppose govt. increases spending on roads

(or other public capital).
-. Better roads may increase business
productivity, which increases the quantity of
g&s supplied, shifts AS to the right.
(5). This effect is probably more relevant in the
long run, as it takes time to build the new
roads and put them into use.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 58

 1.Interest Rate in the Long-run and Short-run
-. Loanable Funds Market vs Liquidity Preference
Theory(LPT)
2. LPT and interest rate
3. Monetary Policy and AD
-. FED and Stock Market (AD)
% L-R: P is neutral, S-R: P changes AD/Y.

4. Fiscal Policy and AD

-. Multiplier, Crowding out and Tax
5. Fiscal Policy and AS: “supply-siders”
6. Stabilization Policy
-. Activist, Opponents
-. Automatic Stabilizers
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 59
6. Using Policy to Stabilize the Economy
 Since the Employment Act of 1946, economic
stabilization has been a goal of U.S. policy.
-. “It is the continuing policy and responsibility of the
federal government to…..promote full employment
and production.”
(a). GOV should avoid being a cause of economic fluctuations/
should not use large and sudden changes in MP/FP.
(b). when large change do occur, GOV should respond to private
economy to stabilize the AD

 Economists debate how active a role the govt

should take to stabilize the economy.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 60

10. A reduction in U.S net exports would shift
U.S. aggregate demand
a. rightward. In an attempt to stabilize the economy, the government
could raise taxes.

b. rightward. In an attempt to stabilize the economy, the government

could cut taxes.

c. leftward. In an attempt to stabilize the economy, the government

could raise taxes.

d. leftward. In an attempt to stabilize the economy, the government

could cut taxes.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 61

6.1. The Case for Active Stabilization Policy
(1). Keynes (General Theory, 1936)
irrational waves of pessimism and optimism
among households and firms, leading to shifts
in AD and fluctuations in output and
employment.
(2). Also, other factors cause fluctuations, e.g.,
• booms and recessions abroad
• stock market booms and crashes
(3). If policymakers do nothing, these fluctuations
are destabilizing to businesses, workers,
consumers.
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 62
6.1. The Case for Active Stabilization Policy
(4).Proponents of active stabilization policy
believe the govt. should use policy
to reduce these fluctuations:
• when GDP falls below its natural rate,
should use expansionary monetary or fiscal
policy to prevent or reduce a recession
• when GDP rises above its natural rate,
should use contractionary policy to prevent or
reduce an inflationary boom

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 63

 6.1.1. Keynesians in the White House
1964(Tax cut), President John F.
Kennedy
• Advisers: James Tobin(1981), Robert Solow
(1987)
(1). Advocated a tax cut - to stimulate the
economy
– John Maynard Keynes’s General Theory
– Stimulate aggregate demand
– Change incentives that people face/ can
alter the aggregate supply of goods and
services
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 64
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Keynesians in the White House
• 1964, President John F. Kennedy
(2). Investment tax credit
• Tax break to firms that invest in new capital
• Higher investment
– Stimulate aggregate demand immediately
– Increase the economy’s productive capacity
over time
(3). Enacted in 1964
• Period of robust economic growth

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 65
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 6.1.1. Keynesians in the White House
(4). Fiscal policy
– Short-run: increase production through higher
aggregate demand
– Long-run: increase production through higher
aggregate supply
(5). 2009, President Barak Obama
– Economy in recession
– Policy: stimulus bill (TARP,$700 BIL)
• Substantial increase in government spending

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 66
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
6.2. The Case Against Active Stabilization
Policy
(1). Monetary policy affects economy with a long
lag:
• firms make investment plans far in advance,
so INV takes time to respond to changes in r
• most economists believe it takes at least
6 months for MP to affect output and
employment
(2). Fiscal policy also works with a long lag:
• Changes in G and T require Acts of Congress.
• The legislative process can take months or
years.
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 67
6.2. The Case Against Active Stabilization
Policy
(3). Due to these long lags,
critics of active policy argue that active policies
may destabilize the economy rather than help
it:
By the time the policies affect AD,
the economy’s condition may have changed.
(4). These critics contend that policymakers
should focus on long-run goals, like economic
growth and low inflation.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 68

 1.Interest Rate in the Long-run and Short-run
-. Loanable Funds Market vs Liquidity Preference
Theory(LPT)
2. LPT and interest rate
3. Monetary Policy and AD
-. FED and Stock Market (AD)
% L-R: P is neutral, S-R: P changes AD/Y.

4. Fiscal Policy and AD

-. Multiplier, Crowding out and Tax
5. Fiscal Policy and AS: “supply-siders”
6. Stabilization Policy
-. Activist, Opponents
-. Automatic Stabilizers
CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 69
 6.3. Automatic Stabilizers
(1). Automatic stabilizers:

-. Changes in FP that stimulate AD when

economy goes into recession, without
policymakers having to take any deliberate
action.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 70

6.3.Automatic Stabilizers: Examples
(2). The tax system
• Income, earnings, profits all fall in recession
• Taxes are tied to economic activity.
When economy goes into recession, taxes (amount
of taxes collected) fall automatically.
• This stimulates AD and reduces the magnitude of
fluctuations.
• Y = C(Y-T) + I + G + NX.
Y=130 T=52 (40%) DI=78 c=62 (+11%)
Y=100(-23%) T=30 (30%) DI=70 c=56 (-10%)
Y=70 (-30%) T=14 (20%) DI=56 c=45 (-20%)

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 71

6.3.Automatic Stabilizers: Examples
(3). Govt spending
• In a recession, incomes fall and U-Rate rises.
• More people apply for public assistance
(e.g., unemployment insurance, welfare
benefits).
• Govt outlays on these programs automatically
increase, which stimulates AD and reduces the
magnitude of fluctuations.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 72

 7. CONCLUSION
 Policymakers need to consider all the effects of
their actions. For example,
(1). When Congress cuts taxes, it needs to
consider the short-run effects on AD
and employment, and the long-run effects
on saving and growth.
(2). When the Fed reduces the rate of money
growth, it must take into account not only the
long-run effects on inflation, but the short-run
effects on output and employment.

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 73

 Review
1. Macroeconomics investigates each country’s
( ).
2. SOL depends on in the LR, ( )
SR, ( )
3. Price is a ( ) in the LR but in the SR P does
change ( ) / ( ).
4. FP/MP can stabilize ( )/( ).

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 74

 Homework
 Page 485
 #1, #3, #4
 Due next Wednesday

CHAPTER 21 THE INFLUENCE OF MONETARY AND FISCAL POLICY 75