Monetary and Fiscal Policies

Short-Run Economic Fluctuation

Economic activity fluctuates from year to year.A recession is a period of declining real

incomes, and rising unemployment.A depression is a severe recession.• Fluctuations in the economy are often called the

business cycle.

Basic Model Two variables are used to develop a model

to analyze the short-run fluctuations. The economy’s output of goods and services

measured by real GDP. The overall price level measured by the CPI or the

GDP deflator. The Basic Model of Aggregate Demand

and Aggregate Supply Economist use the model of aggregate demand and

aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

Aggregate Demand and Supply Curves

The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

Aggregate Demand and Aggregate Supply

Quantity ofOutput

PriceLevel

0

Aggregatesupply

Aggregatedemand

Equilibriumoutput

Equilibriumprice level

Aggregate Demand Curve The four components of GDP (Y)

contribute to the aggregate demand for goods and services.

Y = C + I + G + NX

The Aggregate-Demand Curve...

Quantity ofOutput

PriceLevel

0

Aggregatedemand

P

Y Y2

P2

1. A decreasein the pricelevel . . .

2. . . . increases the quantity ofgoods and services demanded.

Shifts Shifts arising from

Consumption Investment Government Purchases Net Exports

Demand Curve Shifts

Quantity ofOutput

PriceLevel

0

Aggregatedemand, D1

P1

Y1

D2

Y2

Aggregate Supply Curve In the long run, the aggregate-supply

curve is vertical. In the short run, the aggregate-supply

curve is upward sloping.

The Long-Run Aggregate-Supply Curve

Quantity ofOutput

Natural rateof output

PriceLevel

0

Long-runaggregate

supply

P2

1. A changein the pricelevel . . .

2. . . . does not affect the quantity of goods and services supplied in the long run.

P

Long-Run Aggregate Supply Curve

The Long-Run Aggregate-Supply Curve The long-run aggregate-supply curve is vertical at

the natural rate of output. This level of production is also referred to as

potential output or full-employment output. Any change in the economy that alters the

natural rate of output shifts the long-run aggregate-supply curve.

The shifts may be categorized according to the various factors in the classical model that affect output.

Shifts Shifts arising

Labor Capital Natural Resources Technological Knowledge

Long-Run Growth and Inflation

Quantity ofOutput

Y1980

AD1980

AD1990

Aggregate Demand, AD2000

PriceLevel

0

Long-runaggregate

supply,LRAS1980

Y1990

LRAS1990

Y2000

LRAS2000

P1980

1. In the long run,technological progress shifts long-run aggregate supply . . .

4. . . . andongoing inflation.

3. . . . leading to growthin output . . .

P1990

P2000

2. . . . and growth in the money supply shifts aggregate demand . . .

Short-Run Aggregate Supply Curve

Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.

In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied.

A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

The Short-Run Aggregate-Supply Curve

Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

1. A decreasein the pricelevel . . .

2. . . . reduces the quantityof goods and services

supplied in the short run.

Y

P

Y2

P2

The Long-Run Equilibrium

Natural rateof output

Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

Long-runaggregate

supply

Aggregatedemand

AEquilibriumprice

Two Causes of Economic Fluctuation

Shifts in Aggregate Demand In the short run, shifts in aggregate demand cause fluctuations in the

economy’s output of goods and services. In the long run, shifts in aggregate demand affect the overall price

level but do not affect output. An Adverse Shift in Aggregate Supply

A decrease in one of the determinants of aggregate supply shifts the curve to the left: Output falls below the natural rate of employment. Unemployment rises. The price level rises

A Contraction in Aggregate Demand

Quantity ofOutput

PriceLevel

0

Short-run aggregatesupply, AS

Long-runaggregate

supply

Aggregatedemand, AD

AP

Y

AD2

AS2

1. A decrease inaggregate demand . . .

2. . . . causes output to fall in the short run . . .

3. . . . but over time, the short-runaggregate-supplycurve shifts . . .

4. . . . and output returnsto its natural rate.

CP3

BP2

Y2

An Adverse Shift in Aggregate Supply

Quantity ofOutput

PriceLevel

0

Aggregate demand

3. . . . and the price level to rise.

2. . . . causes output to fall . . .

1. An adverse shift in the short-run aggregate-supply curve . . .

Short-runaggregate

supply, AS

Long-runaggregate

supply

Y

AP

AS2

B

Y2

P2

Stagflation Stagflation

Adverse shifts in aggregate supply cause stagflation—a period of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand

cannot offset both of these adverse effects simultaneously.

Policy Responses to Recession Policy Responses to Recession

Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using

monetary and fiscal policy.

Accommodating an Adverse Shift in Aggregate Supply

Quantity ofOutput

Natural rateof output

PriceLevel

0

Short-runaggregate

supply, AS

Long-runaggregate

supply

Aggregate demand, AD

P2

AP

AS2

3. . . . whichcauses theprice level to rise further . . .

4. . . . but keeps outputat its natural rate.

2. . . . policymakers canaccommodate the shiftby expanding aggregatedemand . . .

1. When short-run aggregatesupply falls . . .

AD2

CP3

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Equilibrium in the Money Market

Quantity ofMoney

InterestRate

0

Moneydemand

Quantity fixedby the Fed

Moneysupply

r2

M2dMd

r1

Equilibriuminterest

rate

Price and Quantity Demanded The price level is one determinant of the quantity of money

demanded. A higher price level increases the quantity of money demanded

for any given interest rate. Higher money demand leads to a higher interest rate. The quantity of goods and services demanded falls. The end result of this analysis is a negative relationship

between the price level and the quantity of goods and services demanded.

The Money Market and the Slope of the Aggregate-Demand Curve

Quantityof Money

Quantity fixedby the Fed

0

InterestRate

Money demand at price level P2, MD2

Money demand atprice level P , MD

Moneysupply

(a) The Money Market (b) The Aggregate-Demand Curve

3. . . . whichincreasesthe equilibriuminterestrate . . .

2. . . . increases thedemand for money . . .

Quantityof Output

0

PriceLevel

Aggregatedemand

P2

Y2 Y

P

4. . . . which in turn reduces the quantityof goods and services demanded.

1. Anincreasein thepricelevel . . .

r

r2

Fed’s Monetary Injection The Fed can shift the aggregate demand

curve when it changes monetary policy. An increase in the money supply shifts

the money supply curve to the right. Without a change in the money demand

curve, the interest rate falls. Falling interest rates increase the quantity

of goods and services demanded.

A Monetary Injection

MS2Moneysupply, MS

Aggregatedemand, AD

YY

P

Money demand at price level P

AD2

Quantityof Money

0

InterestRate

r

r2

(a) The Money Market (b) The Aggregate-Demand Curve

Quantityof Output

0

PriceLevel

3. . . . which increases the quantity of goods and services demanded at a given price level.

2. . . . theequilibriuminterest ratefalls . . .

1. When the Fedincreases themoney supply . . .

Impacts of Monetary Policy on Aggregate Demand

When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the right.

When the Fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the left.

Forms of Monetary Policy Monetary policy can be described either in

terms of the money supply or in terms of the interest rate.

Changes in monetary policy can be viewed either in terms of a changing target for the interest rate or in terms of a change in the money supply.

A target for the federal funds rate affects the money market equilibrium, which influences aggregate demand.

Fiscal Policy Fiscal policy refers to the government’s

choices regarding the overall level of government purchases or taxes.

Fiscal policy influences saving, investment, and growth in the long run.

In the short run, fiscal policy primarily affects the aggregate demand.

Fiscal Policy: continued When policymakers change the money

supply or taxes, the effect on aggregate demand is indirect—through the spending decisions of firms or households.

When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly.

Two Macroeconomic Effects There are two macroeconomic effects

from the change in government purchases: The multiplier effect The crowding-out effect

The Multiplier Effect

Quantity ofOutput

PriceLevel

0

Aggregate demand, AD1

$20 billion

AD2

AD3

1. An increase in government purchasesof $20 billion initially increases aggregatedemand by $20 billion . . .

2. . . . but the multipliereffect can amplify theshift in aggregatedemand.

The Crowding-Out Effect

Quantityof Money

Quantity fixedby the Fed

0

InterestRate

r

Money demand, MD

Moneysupply

(a) The Money Market

3. . . . whichincreasesthe

equilibriuminterestrate . . .

2. . . . the increase inspending increasesmoney demand . . .

MD2

Quantityof Output

0

PriceLevel

Aggregate demand, AD1

(b) The Shift in Aggregate Demand

4. . . . which in turnpartly offsets theinitial increase inaggregate demand.

AD2

AD3

1. When an increase in government purchases increases aggregatedemand . . .

r2

$20 billion