ch35 influence of monetary fiscal policy on ag demand

3 reasons for curve downward slope

Wealth effect ; interest rate effect ; exchange rate effect — all work simultaneously to increase the quantity of goods and services demanded when price level falls and vice versa

Wealth effect

Lower price level raises real value of household money holdings

Interest rate effect

Lower price level reduces amount of money people want to hold As ppl try lend out excess, interest rate fall. Stimulates investment spending thus increase quant of good demanded

The 3 effects are not of equal importance

Wealth effect least important (money holding only small part of household wealth). Exchange rate effect not large for US (but could be for smaller country bc export/import larger fraction of GDP). most important for US is interest rate effect

Theory of liquidity preference

Keynes’s theory that interest rate adjusts to bring money supply and money demand into balance

When borrowers and lenders expect prices to rise over term of the loan they agree to a nominal interest rate that exceeds the real interest rate by the expected rate of inflation

The higher nominal interest rate compensates for the expectation that the loan will be repaid in less valuable dollars

Why is there always some demand for money

People choose to hold money instead of other assets that offer higher rates of return bc they can use to buy goods and services

Interest rate

Represents opp cost of holding money (you lose interest you could have earned if you hold wealth as cash rather than interst bearing bond or bank deposit)

Interest rate effect and why downward slope aggregate demand curve

Higher price level raises money demanded which increases interest rate which decreases Q of goods and services demanded. Hence when price level rises, quantity of goods and services demanded decrease

Whenever the q of goods and services demanded changes for any price level, the aggregate demand curve shifts

Monetary policy shifts agg demand curve

When fed increases money supply (such as through injections), it lowers the interest rate and increase the Q of goods and services demanded for any price level, shifting the agg demand curve to the right. Vice versa

The role of interest rate targets in fed policy

Federal funds rate

(interest rate that banks charge one another for short term loans), price banks pay to aborrow money from each other. reevaluated every 6 weeks at meeting of the federal open market committee

Why does fed target federal funds rate

Money supply hard to measure precisely, and money demand fluctuates. Federal fund rate allows to accommodate day to day shift in money demand by adjusting money supply accordingly

If banks are borrowing too much and FFR too high

Fed adds money

Changes in monetary policy aimed at expanding aggregate demand can be desc either as increasing money supply or reducing int rate

Vice versa

Liquidity trap

Interest rates are very low, close to 0%. People dont want to spend or invest even if rates go lower. Everyone wants to hold cash (liquidity) bc uncertain about future. So traditional monetary policy STOPS working.

Forward guidance

Central bank commit itself to keeping interest rates low for extended period. Businesses and consumers feel confident borrowing and spending now because they know money will stay cheap in the future.

Quantitative easing

When interest rates are near zero, the Fed buys long-term financial assets, like government bonds or mortgage-backed securities. This increases money supply and decrease long term interest rate. Encourage borrow and spend

Fiscal policy

Setting of levels of gov spending and taxation by gov policymakers

When policymakers change the money supply or level of taxes, they shift agg demand curve indirectly by influencing spending decisions of firms or households.

BUT when gov alters their own purchase it shifts agg demand curve directly

Lets say US department of defense place 20 billion dollar order for fighter planes

Size of shift in aggregate demand may DIFFER from change in gov purchase (so not 20 billion) bc multiplier effect and crowding out effect

Multiplier effect

Additional shifts in agg demand that result when expansionary fiscal policy inc income and thereby consumer spending (positive feedback loop)

Investment accelerator

Positive influence of demand on investment

Marginal propensity to consume

Fraction of extra income that household consumes rather than saves

Multiplier = 1 / (1 - MPC)

Multiplier effect applies to any event that alters spending on any component of gdp

Consumption investment gov purchase or NX

Crowding out effect

Offset in agg demand that results when expansionary fiscal policy raises interest rate and thereby reduce investment spending

Changes in taxes can also affect fiscal policy

When gov cuts personal income tax, increases additional income and can spend on consumer goods. TAX CUT Agg demand curve shift right. But also affected by multiplier and crowd out effects

People perception about whether the tax change is perm or temporary

Determines size of shift in ag demand . if permanent, increase spending by large amount.

Active stabilization policy

FOMC - to prevent adverse effect of raising taxes, can increase money supply. Reduce interest rate, stimulate investment spending and expand aggregate demand. If monetary policy is set appropriately, combined changes in monetary and fiscal policy could leave the aggregate demand for goods and services unaffected.

Employment act of 1946

hold gov accountable for short run macroeconomic performance

Two implications of employment act

1-gov should avoid being a cause of econ fluctuation. 2- gov as much as poss respond to changes in private economy to stabilize aggregate demand

Keynes

Aggregate demand fluctuates bc of largely irrational waves of pessimism and optimism. Pessimism? Household reduce consumption spending and firms reduce investment spending. Result = reduced agg demand, lower production higher unemployment

Argument against active stabilization

Policies operate with long lag. Most believe at least six months for changes in monetary policy to have much effect on output and employment. Fiscal policy also works with lag to implement - so can cause more destabilizing

Automatic stabilizers

Changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession but occur w/o policymakers having to take any deliberate action

Automatic stabilizer = tax system

When recession, gov tax collection decline automatically bc almost all tax closely tied to econ activity. Gov tax revenue falls… automatic tax cut stimulates aggregate demand and reduces magnitude of economic fluctuation

Some government spending also acts as automatic stabilizer

More people eligible for unemployment insurance benefits, welfare, income support