Macroeconomics – Aggregate Demand, Fiscal & Monetary Policy, and Exchange Rates

Keynesian Foundations and Government Intervention

• Origin & Core Idea

  • Developed by John Maynard Keynes during the Great Depression.
  • Rejects “classical” self-correcting markets; instead, recessions can persist without policy help.
  • Central prescription: use ACTIVE fiscal and monetary policy to manage AD (aggregate demand) and stabilize output and employment.
  • Interface often labeled Keynesian Theory mechanism (K.T. mechanism) – links policy changes → spending decisions → output/employment.

• Policy Emphasis

  • Fiscal policy (taxes, transfers, government spending).
  • Monetary policy (money supply, interest rates).
  • Multiplier effect: small policy changes can generate larger movements in real GDP because spending induces further spending.

• Expectations & Animal Spirits

  • Keynes highlighted the role of business/consumer expectations in driving investment & consumption.
  • Policy credibility can shape expectations, amplifying or muting intended effects.

Aggregate Demand & Aggregate Supply (AD-AS) Basics

• Definition of Aggregate Demand (AD)

  • Total planned spending on domestic final goods & services at each price level.
  • Components: Y = C + I + G + X - M where
  • C = consumption expenditure
  • I = investment
  • G = government purchases of goods & services
  • X = exports
  • M = imports

• Relationship with Price Level

  • Inverse relationship: other things equal, higher price level → lower real GDP demanded (movement up ALONG AD curve).
  • Lower price level → higher real GDP demanded (movement down along AD).

• Shifts in AD ("Changes in AD")

  • Rightward shift = increase in AD; leftward shift = decrease.
  • Non-price determinants:
  • Expectations (future income, inflation, profits)
  • Fiscal policy & monetary policy (taxes, transfers, gov’t spending, money supply, interest rate)
  • Global factors (foreign income, exchange rate)

• Aggregate Demand Multiplier

  • Step 1 – Initial autonomous increase (e.g., \Delta I).
  • Step 2 – Income rises.
  • Step 3 – Higher income → higher induced consumption → total \Delta Y exceeds initial \Delta I.
  • Graphically AD shifts more than the initial spending injection.

Fiscal Policy

Definitions

• Fiscal policy = deliberate changes in government outlays or tax revenues.
• Purpose: influence AD, close output gaps, and affect long-run growth.

Automatic vs Discretionary

• Automatic fiscal policy

  • Triggered by current economic conditions without new legislation.
  • Built-in stabilizers: progressive taxes ("induced taxes"), unemployment insurance, welfare.
  • Recession → tax revenue ↓ & transfers ↑ = automatic stimulus (reduces recessionary gap).
  • Expansion → tax revenue ↑ & transfers ↓ = automatic restraint (reduces inflationary gap).

• Discretionary fiscal policy

  • Requires explicit Congressional (parliamentary) action.
  • Examples: new infrastructure bill, temporary tax rebate, “Cash for Clunkers.”
  • Multiplier still applies: AD changes by more than initial \Delta G or \Delta T.

Successful Stimulus Illustration

• Scenario: Potential GDP =\$16\text{T}; Actual =\$15\text{T} ( \$1\text{T} recessionary gap).
• Policy: raise G or cut T.
• With multiplier, AD shifts right from AD0 to AD1.
• Outcome: Real GDP returns to potential, price level rises moderately (e.g., from 100 → 105).

Supply-Side Interaction

• Some fiscal tools affect BOTH AD & AS.
  • Tax cuts raise disposable income (AD) AND improve incentives to work/save/invest (AS).
  • Result can be higher real GDP with ambiguous effect on price level depending on relative shifts.

Long-Run Fiscal Concerns

• Persistent large deficits may crowd out investment, slowing capital accumulation ("Lucas wedge").
• Rising public debt can erode confidence → inflation risk.
• Principle: keep outlays & deficits under control to safeguard growth & price stability.

Monetary Policy & The Federal Reserve (or Central Bank)

Dual Mandate

• 1) Stable prices (low inflation)
• 2) Maximum sustainable employment (real GDP near potential; unemployment near natural rate)

Policy Instruments

• The central bank controls the monetary base; can target
  • Quantity of base OR
  • Price of base = federal funds rate (Malaysia: Overnight Policy Rate).
• Cannot simultaneously fix both.
• Rule of thumb: ↓ monetary base → ↑ federal funds rate; ↑ monetary base → ↓ rate.

Transmission Mechanism (Ripple Chart Summary)

1. FOMC sets new federal funds target (raise = "tighten"; lower = "ease").
2. Other short-term interest rates & exchange rate adjust almost immediately.
3. Bank reserves shift → money supply & loanable funds adjust.
4. Long-term real interest rate moves.
5. Consumption, investment, net exports respond (interest-sensitive spending).
6. AD shifts.
7. Roughly 1 year later: real GDP growth changes.
8. Roughly 2 years later: inflation responds.

• Reality check: timing lags are variable; policymaking is complicated by these delays.

Interest-Rate Channel

• Central bank first impacts federal funds rate.
• Quick pass-through to Treasury bills, corporate paper, etc.

Exchange-Rate Channel

• Higher U.S. rates ↑ interest-rate differential → dollar appreciates; opposite for easing.
• Dollar appreciation → cheaper imports, costlier exports → net exports ↓ (reinforces tightening).

Exchange Rates & Foreign Exchange Market

Fundamentals

• Foreign exchange rate = PRICE of one currency in terms of another (e.g., euros per dollar).
• Determined by supply & demand for the currency.

Demand for Dollars

• Quantity demanded = planned purchases of \ in forex market per period.
• Depends on
  • Current exchange rate (inverse relationship per Law of Demand)
  • Exports effect: lower \$/€ → U.S. goods cheaper → exports ↑ → \ demand ↑.
  • Expected profit effect: lower rate → expectation of future appreciation → \ demand ↑.
  • U.S. vs foreign interest rates (interest-rate differential).
  • Expected future exchange rate.
• Shifters: ↑ U.S. interest differential or ↑ expected future rate → demand curve shifts RIGHT.

Supply of Dollars

• U.S. residents supply \ when they buy foreign currency (imports or asset purchases).
• Law of Supply: higher exchange rate → Americans find foreign goods cheaper → imports ↑ → \ supply ↑.
• Influences: same trio (current rate, interest differential, expected future rate).
• Shifters: ↑ U.S. interest differential or ↑ expected future \$/€ → supply curve shifts LEFT (less supply).

Market Equilibrium

• Intersection of D{\$} and S{\$} yields equilibrium rate.
• Above equilibrium → surplus of \ → rate falls.
• Below equilibrium → shortage → rate rises.

Tariffs (Trade Barriers)

• Definition: Tax on imported (or less commonly exported) goods/services.
• Objectives
  • Protect domestic industries (raising foreign prices → domestic goods relatively cheaper).
  • Generate government revenue.
  • Influence diplomatic/trade relationships.
• Economic Effects
  • Protectionism: domestic firms gain; foreign exporters lose; consumers pay higher prices.
  • Potential for trade wars via retaliatory tariffs.
  • Distorts resource allocation and can reduce overall welfare.

Graph & Figure Highlights (Verbal Descriptions)

• AD curve slopes downward; price-level increase from 95 → 125 causes real GDP demanded to fall from 17\text{T} to 15\text{T}.
• Shift diagrams (Fig 29.5): rightward shift of AD from AD0 to AD1 when expectations or policy turn expansionary; opposite for contraction.
• Multiplier diagram (Fig 29.6): initial injection shifts AD to AD0+\Delta I; induced consumption causes further shift to AD1.
• Fiscal stimulus (Fig 32.2): \$1\text{T} gap closed via \Delta E and multiplier, raising PL to 105.
• Combined AD-AS (Fig 32.4): tax cut both raises AD and AS; real GDP increases without necessary inflation.
• Exchange-rate figures show downward-sloping D{\$} and upward-sloping S{\$}; equilibrium at 0.70 euros per dollar.

Key Formulas & Quantitative References

• Aggregate Demand identity: Y = C + I + G + X - M
• U.S. interest rate differential: i{US} - i{foreign}
• Monetary policy: inverse relation between monetary base B and federal funds rate i_{ff} (qualitative).
• Recessionary gap size: Gap = Y{potential} - Y{actual} (e.g., 16T - 15T = 1T).

Ethical & Practical Implications

• Policy trade-offs: Fighting unemployment vs triggering inflation.
• Long-run debt sustainability and intergenerational equity.
• Currency interventions can spark competitive devaluations.
• Tariffs protect some jobs but harm consumers and export sectors.

Connections & Real-World Context

• Great Depression origin of Keynesian activism; parallels with 2008–09 crisis stimulus.
• Cash for Clunkers (2009 US) – discretionary fiscal program to boost auto sales & replace inefficient vehicles; illustrates induced spending chain.
• Lucas Wedge concept from supply-side economics: cumulative output loss when growth slows due to crowd-out.
• Global monetary spillovers: U.S. rate hikes in 2022 triggered dollar appreciation, affecting emerging-market debt.

Study Tips

• Always distinguish movements ALONG curves (price-level or exchange-rate changes) from SHIFTS of curves (policy, expectations, foreign income).
• Link fiscal & monetary actions to the multiplier and transmission lags—timing matters on exams.
• Practice drawing AD-AS and forex diagrams; annotate demand/supply shifters.
• Remember the dual mandate goals and the sequence in monetary transmission (rates → spending → AD → GDP → inflation).
• Use numerical examples (e.g., \$1\text{T} gap) to calculate required fiscal stimulus with a given multiplier (\text{multiplier} = \frac{1}{1-MPC}).