Macroeconomics Lecture: Aggregate Demand, Fiscal & Monetary Policy, and Exchange Rates

Keynesian Economics

• Core Idea: The economy can be stabilized & recessions mitigated through active government management of aggregate demand.
  • Emphasizes government intervention—contrasts with “classical” self-correcting markets.
  • Originated with John Maynard Keynes during the Great Depression.
• Policy Toolkit:
  • Fiscal policy: changes in taxes, transfers, government spending.
  • Monetary policy: manipulation of interest rates & the money supply.
  • Both are considered “activist” tools; together called the Keynesian Theory mechanism (KT mechanism).
• Growth Emphasis: During downturns, private-sector demand is insufficient; the state must step in to push the economy toward full-employment growth.

Government Intervention Overview

• Two broad levers:
  • Monetary policy (central bank driven)
  • Adjusts interest rates; controls money supply.
  • Central focus on the multiplier effect & the role of expectations.
  • Fiscal policy (legislature/executive driven)
  • Expansionary actions in recession: ↑G, ↑transfers, ↓taxes.
  • Contractionary actions in inflation: ↓G, ↓transfers, ↑taxes.
• Goal: Aggregate-demand management to keep GDP near potential.

Tariffs

• Definition: Tax on imported (or sometimes exported) goods & services.
• Purposes:
  • Protect domestic industries (protectionism).
  • Raise government revenue.
  • Influence diplomatic / trade relations (can trigger trade wars).
• Types:
  • Import tariff (common).
  • Export tariff (rare).
• Economic Effects: ↑prices for consumers, shifts demand to domestic suppliers, possible retaliation from trade partners.

Aggregate Demand (AD) Basics

• Formal identity: Y = C + I + G + X - M
  • C: Consumption, I: Investment, G: Government expenditure, X: Exports, M: Imports.
• Relation with price level (P):
  • Other things constant: ↑P → ↓quantity of real GDP demanded; ↓P → ↑quantity demanded.
  • Illustrated by downward-sloping AD curve.

Shifts in AD (non-price factors)

• Expectations: future income, inflation, profits.
• Fiscal & Monetary policy: changes in G, T, money, interest rates.
• World economy: foreign incomes, exchange rate changes.
  • ↓Exchange rate (domestic currency depreciates) → ↑net exports → AD shifts right.
  • ↑Exchange rate (appreciation) → ↓net exports → AD shifts left.

Aggregate Demand Multiplier

• Concept: Initial change in expenditure → larger overall change in AD.
  • Example path: ↑Investment → ↑income → ↑consumption → total AD rises by more than initial \Delta I.
• Graphically: AD0 → AD0+I → AD1 (final multiplied shift).

Fiscal Policy in Detail

Automatic (Built-In) Stabilizers

• Triggered automatically by economic conditions.
  • Induced taxes: tax revenues linked to GDP (↓ in recession, ↑ in boom).
  • Transfers/outlays: unemployment benefits rise in recession.
• Act to dampen business cycle without new legislation (automatic stimulus/restraint).

Discretionary Fiscal Policy

• Requires explicit congressional action.
  • e.g.
  • “Cash for Clunkers” car-purchase subsidy.
  • One-time tax rebate or defense-spending increase.
• Multiplier effect: A \Delta G or \Delta T leads to >-proportionate \Delta in AD.

Illustrative Scenario

• Potential GDP =\$16\text{ trillion}; actual GDP =\$15\text{ trillion} (recessionary gap =\$1\text{ trillion}).
  • Government can ↑G or ↓T to shift AD right by \Delta E.
  • With multiplier, AD reaches full-employment output; P might rise from, say, 100→105.

Supply-Side Interactions

• Simultaneous AD & AS shifts:
  • A tax cut ↑disposable income (AD right) AND improves incentives to work/invest (AS right).
  • Net result: ↑Real GDP; price effect ambiguous (could ↑, ↓, or stay constant).
• Long-run risks:
  • Persistent budget deficits crowd out investment, slowing growth (“Lucas wedge”).
  • Rising debt undermines currency confidence → potential inflation.

Monetary Policy: The Dual Mandate

• Goals (Federal Reserve / most central banks):
  • Stable prices (low inflation).
  • Maximum employment (GDP at potential, unemployment at natural rate).

Policy Instrument Choice

• Fed controls the monetary base—can target either its quantity or its price (federal funds rate, i_{ff}), but not both simultaneously.
  • i_{ff} = overnight inter-bank reserve rate (Malaysia ≈ Overnight Policy Rate).
  • ↓Monetary base ↔ ↑i{ff}; ↑Monetary base ↔ ↓i{ff}.

Monetary Policy Transmission Mechanism

1. FOMC decision: change i_{ff}.
2. Ripples to other short-term rates & exchange rate (interest differential effect).
3. Bank reserves adjust → changes in deposits & loan supply.
4. Long-term real interest rate shifts through loanable-funds market.
5. Expenditure channels (C, I, NX) react.
6. Aggregate demand moves.
7. Real GDP growth responds (≈1-year lag).
8. Inflation responds (≈2-year lag).

• Implementation difficulty: long, variable lags → forecasting challenges.

Exchange Rate Determination

• Exchange rate viewed as the price of one currency in terms of another (e.g., euros per dollar).

Demand for Dollars (Foreigners buying )

• Depends on
  • Current exchange rate (law of demand: ↑E → ↓Q demanded).
  • U.S. vs foreign interest rates (interest differential = i{US}-i{foreign}).
  • Expected future exchange rate.
• Exports effect: cheaper $ → ↑U.S. exports → ↑dollar demand.
• Expected-profit effect: lower current $ → anticipated appreciation → ↑demand.

Supply of Dollars (Americans selling )

• Law of supply: ↑E → ↑Q supplied.
• Determinants mirror demand side:
  • Exchange rate, interest differential, expected future rate.
• Imports effect: stronger $ → cheaper imports → ↑dollar supply.
• Expected-profit effect: expectations of depreciation encourage selling $ now.

Shifts vs Moves along Curves

• Non-price factors (interest diff., expectations) shift D or S curves.
  • ↑U.S. interest differential: D$ shifts right; S$ shifts left.
  • ↑Expected future $: D$ right; S$ left.

Market Equilibrium

• Intersection of D$ & S$ ⇒ equilibrium exchange rate.
  • Surplus (E too high) → $ depreciates.
  • Shortage (E too low) → $ appreciates.

Key Numerical & Graphical Points

• GDP Price Index base year 2009 =100 used in all AD/AS diagrams.
• Example price levels & GDP quantities:
  • At P=135, AD quantity ≈ 15.0\text{ T}; at P=85, AD quantity ≈ 17.0\text{ T}.
• Exchange-rate graphs show equilibrium around 0.70 euros/$ where Q ≈ 1.3\text{ T dollars/day}.

Ethical / Practical Implications

• Policy activism vs market self-correction: Keynesian view justifies moral obligation for government support during hardship.
• Tariff usage: Protects jobs yet raises consumer costs; retaliatory risks question fairness.
• Budget discipline: Long-run fiscal prudence essential to prevent inflation & inter-generational debt burdens.
• Central-bank transparency: Crucial because lagged effects mean current actions shape future living standards.

Connections to Previous / Broader Concepts

• Builds on classical AS/AD framework but inserts Keynesian demand management.
• Multiplier connects to marginal propensity to consume (MPC) formula k = \frac{1}{1 - MPC} (implied though not explicitly shown).
• Interest-rate parity in FX links monetary policy to exchange rates.
• Automatic stabilizers tie into public-finance concepts of cyclically-adjusted budget balance.

Study Tips

• Memorize the income identity Y = C + I + G + X - M and be ready to explain each component.
• Practice shifting AD/AS curves for various policy changes; annotate price-level & output effects.
• Understand time lags: ~1 year for GDP, ~2 years for inflation after Fed moves.
• Be able to derive qualitative FX market outcomes when U.S. interest rates or expectations change.
• Revisit multiplier arithmetic: initial \$1\text{ B} ↑G could yield >\$1\text{ B} ↑GDP, magnitude depends on MPC.