Macroeconomics

5.0 Fiscal & Monetary Policy (cont'd)

1. Money, Interest and Aggregate Demand                                                                      

(MKM C15/379-82; 401-3; 410-13: 356-59; 376-77;  384-87; 366-368; C16/395-396; 340-342; 371-372)                                                                

- how fiscal and monetary policy affect real GDP and the price level

a) Equilibrium Expenditure & Interest Rate
- will show that equilibrium expenditure depends on investment which in turn depends on interest rate; therefore equilibrium expenditure and real GDP depend on interest rate

i- Money Market
- Let us assume that MS determined by central bank, i.e. for purposes of this analysis MS is fixed or 'given' and therefore 'inelastic'
- we know that demand for money (MD) depends on level of real GDP and that any level of real GDP MD will be downward sloping varying according to the 'price of money', i.e. the interest rate
- therefore for any given level of real GDP  (P&B Fig. 29.1 a) there will be an equilibrium point for MD and MS defined by the fixed level of MS and a specific interest rate

ii- Investment & Interest Rate
- we know that investment is inversely related to the interest rate, i.e. investment will increase as the price of money falls
- therefore given the equilibrium price of money determined in the money market there will be a specific level of investment
iii- Equilibrium Expenditure
- investment is part of 'autonomous expenditure' including government spending and exports
- assuming given levels for government spending and exports, total autonomous expenditure will be measured by a specific intersection point of the AE curve and the x-axis depending on the level of investment determined by the interest rate which in turn is determined by equilibrium in the money market
- induced expenditure (consumption less imports) increases from this point of intersection at a slope reflecting, primarily, the marginal propensity to consume (adjusted for the impact of the tax rate and marginal propensity to import) (R&L Fig. 22-3)

2. Fiscal Policy & Aggregate Demand
- assume government pursues expansionary fiscal policy, i.e. will increase G (P&B Fig. 29.2)
a) First Round

- increase in G shifts AD curve to right

- higher price level, higher real GDP
 

b) Second Round

- increase in real GDP increases demand for money MD₁ to MD ₂

- increased demand for money raises interest rate decreasing I causing AD to shift to left

- but upward movement along new AD curve reflecting rising price level to attain new equilibrium which decreases real supply of money which increases interest rate further (P&B Fig. 29.3)
 

c) Other Fiscal Policies
- increase in G is only one fiscal policy tool available to government.   Another is a change in transfer payments but its impact will be different because of differential effect on MPC, i.e. lower income households have higher MPC therefore it will change slope of AE
- Government can also change tax policy, e.g. a change marginal tax rates will similarly change slope of AE by its impact on MPC
- All these changes will affect interest rate and hence investment and hence AE and AD.
 

d) Crowding Out and Crowding In ( C8 178; C 16 389-392; C8 163; C 16 365-369
- Government borrowing on the financial markets will reduce Investment (I) through 'crowding out'.  Thus government borrowing increases money demand raising interest rates which causes investment to fall (R&L 13th Ed Fig. 32.6; MKM Fig. 15.9).
- This may be partial or complete but usually partial
- However, if increase in G is spent on improvement in infrastructure this can reduce costs of doing business and therefore increase I; or, if the increase in G increases the expectation of economic growth I may increase even if interest rates go up because of business expectation of improved opportunities;

- Similarly, a decrease in business may also increase I.  The impact of improved infrastructure and reduce business costs as well as decrease in business taxes can lead  to ''crowding in", i.e., increased I
- All things being equal crowding in less likely.

e) Exchange Rate and International Crowding Out
- An increase in interest rate tends to increase value of a currency on world markets as foreign funds flow to higher rates.
- There are various effects of an appreciating currency: (i) decreases X reducing autonomous expenditure; (ii) increase in imports decreasing induced expenditures (C-M); (iii) increase in foreign investment increasing I raising autonomous expenditure.

3. Monetary Policy and Aggregate Demand
- Let us assume the central bank decides to pursue expansionary monetary policy.  The effect will depend on the elasticity of the investment function.  The more elastic, the greater the effect; the more inelastic, the less the effect  (R&L 13 Ed Fig. 28-10).
 

a) First Round

- An increase in the MS shifts the curve to right decreasing interest rate and increasing I.  This leads to an increase I shifting AD curve to right increasing real GDP and price level (MBB not displayed; P&B Fig. 29.5).

b) Second Round 

- The increase in real GDP, however, increases MD shifting the curve up to right.  The upward movement of AD curve causes a rising price level (to attain new equilibrium) which decreases real supply of money which increases interest rate further  (P&B Fig. 29.6).