Monetary/Fiscal Policy

Monetary Policy

The supply of money set by the Fed to manage inflation (think of Banks)

Fiscal Policy

Levels of government spending and taxation set by the President and Congress (think gov)

Causes for AD curve sloping down

1) Real Wealth Effect

2) Exchange Rate Effect

3) Interest Rate Effect

Interest rate is…

the opportunity cost for holding money

When the money supply is increased, what happens to the interest rate and quantity of g/s demanded?

Interest rate decreases and the quantity of g/s demanded increases

When the money supply is decreased, what happens to the interest rate and quantity of g/s demanded?

Interest rate increases and the quantity of g/s demanded decreases

Demand relies on…

Borrowers

Who provides the supply of money

Savers

Theory of Liquidity Preference

In the short run, MS and MD are balanced by the interest rate

Money Supply

Fixed by the Fed

Money Demand

Depends on the opportunity cost of holding money (interest rate), price value (P), and real output (Y)

Interest rate > equilibrium

The quantity of money people want to hold is less than the quantity supplied

When happens if Interest rate > equilibrium

People holding the surplus invest, which lowers interest rates. People are more willing to hold money

Interest rate < equilibrium

The quantity of money people want to hold is more than the quantity supplied

When happens if Interest rate < equilibrium

People holding the surplus will sell investments, which raises interest rates. People are less willing to hold money

Crowding out effect

Decrease in investment that results from government borrowing. No saving happens to offset consumption. This may reduce the shift in AD

Market for Loanable Funds (MLF)

Virtual cleaning house that matches savers and borrowers (magical place!)

Borrowers…

Demand loanable funds for investment to buy capital (high interest rates discourage borrowers)

Savers…

Supply loanable funds and hope to earn interest on their savings (High interest rates encourage more savings)

Budget Deficit

When taxes are less than government spending

What to Budget Deficits do?

They increase the government’s demand for loanable funds. Increased interest rates, decreased investment.

Budget Surplus

When taxes are greater then government spending

What do Budget Surpluses do?

They reduce government spending for loanable funds. Decreased interest rates, increased supply of loanable funds.

Why do presidents matter less?

1) Monetary policy is stronger than fiscal policy

2) Presidents don’t control monetary policy

3) They share fiscal policy control with Congress

Multiplier Effect

Additional shifts in AD that result when expansionary fiscal policy increases income, thereby increasing consumer spending

The size of the multiplier effect depends on

How much additional consumption occurs

Why is the market for loanable funds potentially serious for long-term growth and productivity?

In the market of loanable funds, supply and demand establish interest rates

Cases against active stabilization policy:

1) Lags: It takes Congress a while to act

2) By the time the policy takes effect, the issue could be either over or changed. The policy could also make the issue worse