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1、11-1,11-2,11,Monetary and Fiscal Policy,Item ItemItemEtc.,11-3,Introduction,In this chapter we use the IS-LM model developed in Chapter 10 to show how monetary and fiscal policy workFiscal policy has its initial impact in the goods marketMonetary policy has its initial impact mainly in the assets ma
2、rketsBecause the goods and assets markets are interconnected,both fiscal and monetary policies have effects on both the level of output and interest ratesExpansionary/contractionary monetary policy moves the LM curve to the right/leftExpansionary/contractionary fiscal policy moves the IS curve to th
3、e right/left,11-4,Monetary Policy,The Federal Reserve is responsible for monetary policy in the U.S.conducted mainly through open market operationsOpen market operations:buying and selling of government bondsFed buys bonds in exchange for money increases the stock of money(Fig.11-3)Fed sells bonds i
4、n exchange for money paid by purchasers of the bonds reducing the money stock,Insert Figure 11-3 here,11-5,Monetary Policy,Consider the process of adjustment to the monetary expansionAt the initial equilibrium,E,the increase in money supply creates an excess supply of moneyThe public adjusts by tryi
5、ng to buy other assets Asset prices increase,and yields decrease move to point E1Money market clears,with lower interest rateDecline in interest rate results in excess demand for goodsOutput expands and move up LM scheduleFinal position is at E,Insert Figure 11-3 here,again,11-6,Transition Mechanism
6、,Two steps in the transmission mechanism(the process by which changes in monetary policy affect AD):An increase in real balances generates a portfolio disequilibriumAt the prevailing interest rate and level of income,people are holding more money than they wantPortfolio holders attempt to reduce the
7、ir money holdings by buying other assets changes asset prices and yields The change in money supply changes interest ratesA change in interest rates affects AD,Insert Table 11-1 here,11-7,The Liquidity Trap,Two extreme cases arise when discussing the effects of monetary policy on the economy first i
8、s the liquidity trapLiquidity trap=a situation in which the public is prepared,at a given interest rate,to hold whatever amount of money is suppliedImplies the LM curve is horizontal changes in the quantity of money do not shift itMonetary policy has no impact on either the interest rate or the leve
9、l of income monetary policy is powerless Possibility of a liquidity trap at low interest rates is a notion that grew out of the theories of English economist John Maynard Keynes,11-8,Banks Reluctance to Lend,Two extreme cases arise when discussing the effects of monetary policy on the economy second
10、 is the reluctance of banks to lendAnother situation in which monetary policy is powerless to alter the economy break down in the transmission mechanismDespite lower interest rates and increased demand for investment,banks may be unwilling to make the loans necessary for the investment purchasesIf b
11、anks made prior bad loans that are not repaid,may become reluctant to make more,despite demand prefer instead to lend to the government(safer),11-9,The Classical Case,The opposite of the horizontal LM curve(implies that monetary policy cannot affect the level of income)is the vertical LM curveIf LM
12、is vertical=demand for money is entirely unresponsive to the interest rateRecall,the equation for the LM curve is(1)If h is zero,then there is a unique level of income corresponding to a given real money supply VERTICAL LM CURVEThe vertical LM curve is called the classical caseRewrite equation(1),wi
13、th h=0:(2)Implies that NGDP depends only on the quantity of money quantity theory of money,11-10,The Classical Case,When the LM curve is verticalA given change in the quantity of money has a maximal effect on the level of incomeShifts in the IS curve do not affect the level of income Vertical LM cur
14、ve implies the comparative effectiveness of monetary policy over fiscal policy“Only money matters”for the determination of outputRequires that the demand for money be irresponsive to i important issue in determining the effectiveness of alternative policies,When the LM curve is vertical,monetary pol
15、icy has a maximal effect on the level of income,and fiscal policy has no effect on income.,11-11,Fiscal Policy and Crowding Out,The equation for the IS curve is:(3)The fiscal policy variables,G and t,are within this definitionG is a part of At is a part of the multiplierFiscal policy actions,changes
16、 in G and t,affect the IS curveSuppose G increasesAt unchanged interest rates,AD increasesTo meet increased demand,output must increaseAt each level of the interest rate,equilibrium income must rise by,11-12,Fiscal Policy and Crowding Out,If the economy is initially in equilibrium at E,if government
17、 expenditures increases,equilibrium moves to E”The goods market is in equilibrium at E”,but the money market is not:Because Y has increased,the demand for money also increases interest rate increasesFirms planned investment spending declines at higher interest rates and AD falls off move up the LM c
18、urve to E,Insert Figure 11-4 here,11-13,Fiscal Policy and Crowding Out,Comparing E to E:increased government spending increases income and the interest rateComparing E to E”:adjustment of interest rates and their impact on AD dampen expansionary effect of increased GIncome increases to Y0 instead of
19、 Y”,Insert Figure 11-4 here,Increase in government expenditurescrowds out investment spending.,11-14,The Composition of Output and the Policy Mix,Table 11-2 summarizes our analysis of the effects of expansionary monetary and fiscal policy on output and the interest rate(assuming not in a liquidity t
20、rap or in the classical case)Monetary policy operates by stimulating interest-responsive components of ADFiscal policy operates through G and t impact depends upon what goods the government buys and what taxes and transfers it changesIncrease in G increases C along with G;reduction in income taxes i
21、ncreases C,Insert Table 11-2 here,11-15,The Composition of Output and the Policy Mix,Figure 11-8 shows the policy problem of reaching full employment output,Y*,for an economy that is initially at point E,with unemploymentShould a policy maker choose:Fiscal policy expansion,moving to point E1,with hi
22、gher income and higher interest ratesMonetary policy expansion,resulting in full employment with lower interest rates at point E2A mix of fiscal expansion and accommodating monetary policy resulting in an intermediate position,Insert Figure 11-8 here,11-16,The Composition of Output and the Policy Mi
23、x,All of the policy alternatives increase output,but differ significantly in their impact on different sectors of the economy problem of political economyGiven the decision to expand aggregate demand,who should get the primary benefit?An expansion through a decline in interest rates and increased investment spending?An expansion through a tax cut and increased personal consumption?An expansion in the form of an increase in the size of the government?,Insert Figure 11-8 here,
