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1. Money, Interest and Aggregate Demand
- 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 (MBB
10th Ed
Fig. 13.2; MBB 11th Ed Fig. 12.5; PB Fig. 29.1)
- 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 (MBB
10th Ed
Fig. 13.2; MBB 11th Ed Fig. 12.5; PB 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)
2. Fiscal Policy & Aggregate Demand
- assume government pursues expansionary fiscal policy, i.e. will increase G (MBB
not displayed; PB 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 (MBB
not displayed; PB Fig. 29.3)
-
increased demand for money raises interest rate decreasing I causing AD
to shift to left
-
but also 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
c) Other Fiscal Policies
- increase in G only one fiscal policy tool available to government, e.g. change
in transfer payments but impact different because of differential effect on MPC,
i.e. lower income households have higher MPC therefore change slope of AE (not
in text)
- can also change tax policy, i.e. change tax rates which depending on which
rates are change will similarly change slope of AE by impact on MPC (not in
text)
- all will affect interest rate and hence investment
d) Crowding Out and Crowding In
- the tendency of increase in G through borrowing on the financial markets will reduce Investment
is called 'crowding out'
- may be partial or complete, usually partial
- if increase in G spent on improvement in infrastructure can reduce costs of
doing business and therefore increase I; or, if increase in G causes increased
expectation of economic growth I may increase even if interest rates go up in
business expectation of improved opportunities; or decrease in taxes increases
after tax profit rate I may also increase - all these effects called ''crowding
in"
- all things being equal crowding in less likely
e) Exchange Rate and International Crowding Out
- increase in interest rate tends to increase value of currency on world markets
as foreign funds flow to higher rates
- various effects of increased value of currency: decreases X reducing
autonomous expenditure; increases imports decreasing induced expenditures (C-M);
increases foreign investment increasing I raising autonomous expenditure (not in
text)
3. Monetary Policy and Aggregate Demand
- assume central bank decides to pursue expansionary monetary policy
a) First Round (MBB not displayed; PB Fig. 29.5)
-
MS shift to right decreasing interest rate and increasing I
-
increase I shifts AD curve to right increasing real GDP and price level
b) Second Round
-
increase in real GDP increases MD up to right (MBB not displayed; PB Fig. 29.6)
-
but also 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
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