Lecture 9 monetary and fiscal policy

Aggregate Demand Quantity of Output Price Level 0 Aggregate demand P1 P2 M Value... Aggregate demand b Commodity & service Market Quantity of Output 0 Price Level a The Money Market Qua

Macroeconomics

lecture 9

Monetary

and

Fiscal Policy

Chapter 34

Aggregate Demand

Quantity of Output

Price

Level

0

Aggregate demand P1

P2

M Value

Aggregate demand (b) Commodity & service Market

Quantity

of Output 0

Price Level (a) The Money Market

Quantity of Money

Quantity fixed by the CB 0

r1

Money supply Interest Rate

Money demand at price level P1, MD1

Y1 P1

The Money Market and Aggregate Demand

Money demand at price level P2, MD2

2 …increases the demand for money…

1 An increase in the price level…

The Theory of Liquidity Preference

◦The interest rate adjusts to balance the supply and demand for money.

Equilibrium in the Money Market

Quantity fixed

by the CB

Money supply

r2

M d 2

r1

M d 1

Equilibrium interest

rate

Central bank Change Money Supply Or Target Interest rate through:

◦Open-market operations

◦Changing the reserve requirements

◦Changing the discount rate

 change in AD (consumption and investment)

 change in GDP

Monetary Policy

AD2

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

1 When the CB increases the money supply…

Price Level

Aggregate demand, AD1

(a) The Money Market

Quantity

of Money 0

Money supply, MS1

How Monetary Policy Influences Aggregate Demand

◦Three reason for the downward slope of the aggregate-demand curve:

◦The wealth effect

◦The interest-rate effect

◦The exchange-rate effect

◦The most important reason: interest-rate effect.

Strengths of Monetary Policy

◦Powerful to pursue contractionary policies

◦Swift and flexible action

◦Political acceptability

◦Difficult to predict time-lag between action and outcome

◦Weak when trying to stimulate economic activity

Weaknesses of Monetary Policy

The Fiscal Policy

Education Defence Public serv’s Public debt interest Other

Fiscal policy - Measures

◦Government spendings, led to effects:

◦Taxation

Multiplier Effect

Aggregate demand, AD1

Quantity

of Output 0

Price

Level

AD2

1 An increase in government purchases of

$20 billion initially increases aggregate

The Crowding-Out Effect

◦Crowding-out effect: reduction in demand that results when a fiscal expansion raises the interest rate

AD3

4 …which in turn partly offsets the initial increase in aggregate demand.

The Crowding-Out Effect

Aggregate demand, AD1 (b) The Shift in Aggregate Demand

Quantity of Output 0

Price Level (a) The Money Market

Quantity of Money

Quantity fixed by the

Fed 0

r1

Money demand, MD1

Money supply Interest Rate

1 When an increase in government purchases increases aggregate demand…

◦Open to public oversight  transparency

◦More effective in a recession in stimulating AD than monetary policy

◦Easy to target specific groups in the community with

assistance

Strengths of Fiscal Policy

◦Uncertainty of its outcomes

◦Timing/ Implementation lags

◦Political sensitivity

◦“Crowding-out” effect of budget deficit

Weaknesses of Fiscal Policy

CASE STUDY

VN stabilisation policy in 2019?

Background: at closure of 2018

• Real GDP: 659 billion (base year: 2011)

• Estimated growth rate: 7.1%

• Annual inflation rate: 5.25%

GOV issued circular 01 to stabilise the economy Which measures does circular 01 entail?

VN stabilisation policy in 2019

◦Background: at closure of 2018

 Real GDP: 659 billion (base year: 2011)

 Estimated growth rate: 7.02%

 Annual inflation rate: 5.25%

GOV issued circular 01

 To increse the investment and GDP more?

 Or to reduce the inflation rate?

Which measures should circular 01 entail?

Hints: combined monetary and fiscal policy:

• Discout rate?

• Minimal capital requirement at banks?

• State invested infrastructure projects?

• Salary scheme at public sector?