34 the influence of monetary and fiscal policy on aggregate demand

CHAPTER 34 INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND P781 – p783 Explain changes in MS, MD, and r a Traders by the FED’s bond will decrease MS, thereby decrease r b An increase in credit-card availability reduces the cash people choose to hold and decreases MD MDC shifts to the left and r decreases c The Fed reduces bank’s reserve requirements, rr decreases, money multiplier increases, money supply increases MS shifts to the right, r decreases d Household decide to hold more money to use for holiday shopping Money demand increases, r increases e A wave of optimism boosts business investment and expands aggregate demand, AD shifts to the right Price level increases, so does the money demand for transactions R increases MS increases by percent a r decreases b r dec then it is less expensive to borrow, investment will inc, AD shifts to the right In short-run, both output and price level inc c When the economy makes the transition from its short-run equilibrium to its long-run equilibrium, as expected price inc, AS shifts to the left Price level inc d High price level drives up the money demand, thus leads to an inc in interest rate In the long-run, the interest rate is not changed e This analysis is consistent with the previous conclusion that money supply does affect short-run variable but not long-run variable MD inc a MDC shifts to the right while MS stays, r inc Investment dec, AD dec b AD in the situation is shifting to the left In order to push it back to initial position, FED should inc money supply, thus lower r and encourage I c To accomplish this goal by open market operation, FED should buy bonds A permanent tax cut will stimulate greater spending by consumers Consequently, it has larger impact on AD The economy in a recession with high unemployment and low output a b FED might buy bonds in open market operation to increase the money supply, thereby reduce r and shift AD to the right to restore the natural rate of output c d Lower r makes it less expensive to borrow to invest Higher investment in turn boosts AD New legislation allowed backs to pay interest on checking deposits a Now, owners of checking deposits can receive interest on them They would choose to create more this kind to money and thus money demand inc b If the FED had maintained MS while MD had shifted to the right, then r would have increased Higher r would have led AD to shift to the left, thereby reduce aggregate output c To keep the market interest rate constant, FED should have increased the MS r is held back and I inc again AD would have shifted to the right and output would have returned to its natural rate ^G = $10b, ^Y=$30b a m = 1/1-MPC => MPC = 1- 1/m ; m = ^Y/^G = then MPC = 2/3 b Under crowding-out effects, the multiplier effect is reduced Thus, to obtain the same multiplier, the MPC must be larger than the initial one in problem a Tax reduction = 20b; MPC = ¾ a What is the initial effect of the tax reduction on aggregate demand? • Tax reduced, disposable income of people increased, consumption increased, AD increased • The initial effect of the tax reduction of $20 billion is to increase aggregate demand by $20 billion x 3/4 (the MPC) = $15 billion b What additional effects follow this initial effect? What is the total effect of the tax cut on aggregate demand? Additional effects follow this initial effect as the added incomes get spent The second round leads to increased consumption spending of $15 billion x 3/4 = $11.25 The third round gives an increase in consumption of $11.25 billion x 3/4 = $8.44 billion The effects continue indefinitely Adding them all up gives a total effect that depends on the multiplier With an MPC of 3/4, the multiplier is 1/ (1 – 3/4) = So the total effect is $15 billion x = $60 billion Formulation: because the first round spending is MPC x T then ^AD = MPC/ 1-MPC x ^T c How does the total effect of this $20 billion tax cut compare to the total effect of $20 billion increase in government purchases? Why? • Government purchases have an initial effect of the full $20 billion, since they increase aggregate demand directly by that amount The total effect of an increase in government purchases is thus $20 billion x = $80 billion So government purchases lead to a bigger effect on output than a tax cut does • The difference arises because government purchases affect aggregate demand by the full amount, but a tax cut is partly saved by consumers, and therefore does not lead to as much of an increase in aggregate demand d Because the government want to remain the budget deficit, any change in government spending must be accompanied by a change in tax Recall that: Gov multiplier = 1/ 1-MPC Tax multiplier = MPC/ 1- MPC We can see that tax multiplier is small than gov multiplier with the same MPC and initial changes Therefore, if the gov increase the tax and decrease the gov spending by the same amount, the budget balance will not be changed but AD will increase Other things fixed, an increase in government spending will increase the aggregate demand directly ADC will shift to the right To obtain this, government should purchase a quantity of ^Y/m = ^Y x (1-MPC)= 400 x 1/5 = $80b 10.If the FED were committed to maintain the interest rate, the crowding-effect would be diminished, an increase in government purchases would have greater multiplier effect on aggregate demand 11.Expansionary fiscal policy a When the investment accelerator is larger, people tend to invest more when their income increases Therefore, an expansionary fiscal policy is more likely to result in a short-run increase in investment b An increase in r is caused by an increase in money demand by expansionary fiscal policy When investment is more sensitive to r, this policy will have larger impacts on investment 12.Automatic stabilizers a When an economy enters a recession, its national income, earnings and the corporate income all fall, taxes collected on them also falls b When an economy enters a recession, more people rely on government support in form of welfare, unemployment insurance c The government might loosen its strict balanced-budget rule and increase government spending to restore AD in order to reduce the severity of the recession 13.A law to stabilize the price were passed a If AD were contracted, the price level would decrease FED should buy bonds to increase the money supply, and encourage consumption to reverse the ADC The price level would increase (expansionary policy) b If AS shifted adversely, the price level would increase Fed should sell bonds to decrease the money supply and increase r It would be more expensive to borrow to invest Investment decreases and AD shifts to the left The price level would decrease (contractionary policy) c If the policymakers want to attain stable output then they will have to accept fluctuations in the price level ... the initial effect of the tax reduction on aggregate demand? • Tax reduced, disposable income of people increased, consumption increased, AD increased • The initial effect of the tax reduction... reduction of $20 billion is to increase aggregate demand by $20 billion x 3/4 (the MPC) = $15 billion b What additional effects follow this initial effect? What is the total effect of the tax cut on aggregate. .. increase in consumption of $11.25 billion x 3/4 = $8.44 billion The effects continue indefinitely Adding them all up gives a total effect that depends on the multiplier With an MPC of 3/4, the multiplier