CHAPTER

34
The Influence of Monetary and
Fiscal Policy on Aggregate Demand

Economics
PRINCIPLES OF

N. Gregory Mankiw

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In this chapter,
look for the answers to these questions:
 How does the interest-rate effect help explain the
slope of the aggregate-demand curve?
 How can the central bank use monetary policy to
shift the AD curve?
 In what two ways does fiscal policy affect
aggregate demand?
 What are the arguments for and against
using policy to try to stabilize the economy?

2
 Introduction
 Earlier chapters covered:
 the long-run effects of fiscal policy
on interest rates, investment, economic growth
 the long-run effects of monetary policy
on the price level and inflation rate
 This chapter focuses on the short-run effects
of fiscal and monetary policy,
which work through aggregate demand.

THE INFLUENCE OF MONETARY AND FISCAL 3

 Aggregate Demand
 Recall, the AD curve slopes downward for three
reasons:
 The wealth effect the most important
 The interest-rate effect of these effects for
 The exchange-rate effect the U.S. economy

 Next:
A supply-demand model that helps explain the
interest-rate effect and how monetary policy
affects aggregate demand.

THE INFLUENCE OF MONETARY AND FISCAL 4

 The Theory of Liquidity Preference
 A simple theory of the interest rate (denoted r)
 r adjusts to balance supply and demand
for money
 Money supply: assume fixed by central bank,
does not depend on interest rate

THE INFLUENCE OF MONETARY AND FISCAL 5

 The Theory of Liquidity Preference
 Money demand reflects how much wealth
people want to hold in liquid form.
 For simplicity, suppose household wealth
includes only two assets:
 Money – liquid but pays no interest
 Bonds – pay interest but not as liquid
 A household’s “money demand” reflects its
preference for liquidity.
 The variables that influence money demand:
Y, r, and P.
THE INFLUENCE OF MONETARY AND FISCAL 6
 Money Demand
 Suppose real income (Y) rises. Other things equal,
what happens to money demand?
 If Y rises:
 Households want to buy more g&s,
so they need more money.
 To get this money, they attempt to sell some of
their bonds.
 I.e., an increase in Y causes
an increase in money demand, other things equal.

THE INFLUENCE OF MONETARY AND FISCAL 7

ACTIVE LEARNING 1
The determinants of money demand
A. Suppose r rises, but Y and P are unchanged.
What happens to money demand?
B. Suppose P rises, but Y and r are unchanged.
What happens to money demand?

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ACTIVE LEARNING 1
Answers
A. Suppose r rises, but Y and P are unchanged.
What happens to money demand?
r is the opportunity cost of holding money.
An increase in r reduces money demand:
households attempt to buy bonds to take
advantage of the higher interest rate.
Hence, an increase in r causes a decrease in
money demand, other things equal.

9
ACTIVE LEARNING 1
Answers
B. Suppose P rises, but Y and r are unchanged.
What happens to money demand?
If Y is unchanged, people will want to buy the
same amount of g&s.
Since P is higher, they will need more money to
do so.
Hence, an increase in P causes an increase in
money demand, other things equal.

10
 How r Is Determined

Interest
MS MS curve is vertical:
rate
Changes in r do not
affect MS, which is
r1
fixed by the Fed.
Eq’m MD curve is
interest downward sloping:
rate MD1
A fall in r increases
money demand.
M
Quantity fixed
by the Fed
THE INFLUENCE OF MONETARY AND FISCAL 11
 How the Interest-Rate Effect Works
A fall in P reduces money demand, which lowers r.
Interest P
rate MS

r1
P1

r2 P2
MD1 AD
MD2
M Y1 Y2 Y

A fall in r increases I and the quantity of g&s demanded.

THE INFLUENCE OF MONETARY AND FISCAL 12
Monetary Policy and Aggregate Demand
 To achieve macroeconomic goals, the Fed can use
monetary policy to shift the AD curve.
 The Fed’s policy instrument is MS.
 The news often reports that the Fed targets the
interest rate.
 More precisely, the federal funds rate – which
banks charge each other on short-term loans
 To change the interest rate and shift the AD curve,
the Fed conducts open market operations
to change MS.

THE INFLUENCE OF MONETARY AND FISCAL 13

The Effects of Reducing the Money Supply
The Fed can raise r by reducing the money supply.
Interest P
rate MS2 MS1

r2
P1
r1
AD1
MD AD2
M Y2 Y1 Y

An increase in r reduces the quantity of g&s demanded.

THE INFLUENCE OF MONETARY AND FISCAL 14
ACTIVE LEARNING 2
Monetary policy
For each of the events below,
- determine the short-run effects on output
- determine how the Fed should adjust the money
supply and interest rates to stabilize output
A. Congress tries to balance the budget by cutting
govt spending.
B. A stock market boom increases household
wealth.
C. War breaks out in the Middle East,
causing oil prices to soar.
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ACTIVE LEARNING 2
Answers
A. Congress tries to balance the budget by
cutting govt spending.
This event would reduce agg demand and
output.
To offset this event, the Fed should increase
MS and reduce r to increase agg demand.

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ACTIVE LEARNING 2
Answers
B. A stock market boom increases household
wealth.
This event would increase agg demand,
raising output above its natural rate.
To offset this event, the Fed should reduce MS
and increase r to reduce agg demand.

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ACTIVE LEARNING 2
Answers
C. War breaks out in the Middle East,
causing oil prices to soar.
This event would reduce agg supply,
causing output to fall.
To offset this event, the Fed should increase
MS and reduce r to increase agg demand.

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 Fiscal Policy and Aggregate Demand
 Fiscal policy: the setting of the level of govt
spending and taxation by govt policymakers
 Expansionary fiscal policy
 an increase in G and/or decrease in T
 shifts AD right
 Contractionary fiscal policy
 a decrease in G and/or increase in T
 shifts AD left
 Fiscal policy has two effects on AD...
THE INFLUENCE OF MONETARY AND FISCAL 19
 1. The Multiplier Effect
 If the govt buys $20b of planes from Boeing,
Boeing’s revenue increases by $20b.
 This is distributed to Boeing’s workers (as wages)
and owners (as profits or stock dividends).
 These people are also consumers and will spend
a portion of the extra income.
 This extra consumption causes further increases
in aggregate demand.
Multiplier
Multiplier effect:
effect: the
the additional
additional shifts
shifts in
in AD
AD
that
that result
result when
when fiscal
fiscal policy
policy increases
increases income
income
and
and thereby
thereby increases
increases consumer
consumer spending
spending
THE INFLUENCE OF MONETARY AND FISCAL 20
 1. The Multiplier Effect

A $20b increase in G P
initially shifts AD
to the right by $20b.
AD2 AD3
The increase in Y AD1
causes C to rise, P1
which shifts AD
further to the right. $20 billion

Y1 Y2 Y3 Y

THE INFLUENCE OF MONETARY AND FISCAL 21

 Marginal Propensity to Consume
 How big is the multiplier effect?
It depends on how much consumers respond to
increases in income.
 Marginal propensity to consume (MPC):
the fraction of extra income that households
consume rather than save
E.g., if MPC = 0.8 and income rises $100,
C rises $80.

THE INFLUENCE OF MONETARY AND FISCAL 22

 A Formula for the Multiplier
Notation: G is the change in G,
Y and C are the ultimate changes in Y and C
Y = C + I + G + NX identity

Y = C + G I and NX do not change

Y = MPC Y + G because C = MPC Y

1
Y = G solved for Y
1 – MPC

The multiplier

THE INFLUENCE OF MONETARY AND FISCAL 23

 A Formula for the Multiplier
The size of the multiplier depends on MPC.
E.g., if MPC = 0.5 multiplier = 2
if MPC = 0.75 multiplier = 4
if MPC = 0.9 multiplier = 10

A
A bigger
bigger MPC
MPC means
means
1 changes
changes in in Y
Y cause
cause
Y = G
1 – MPC bigger
bigger changes
changes in in C,
C,
which
which in
in turn
turn cause
cause
The multiplier more
more changes
changes in in Y.
Y.

THE INFLUENCE OF MONETARY AND FISCAL 24

Other Applications of the Multiplier Effect
 The multiplier effect:
Each $1 increase in G can generate
more than a $1 increase in agg demand.
 Also true for the other components of GDP.
Example: Suppose a recession overseas
reduces demand for U.S. net exports by $10b.
Initially, agg demand falls by $10b.
The fall in Y causes C to fall, which further
reduces agg demand and income.

THE INFLUENCE OF MONETARY AND FISCAL 25

 2. The Crowding-Out Effect
 Fiscal policy has another effect on AD
that works in the opposite direction.
 A fiscal expansion raises r,
which reduces investment,
which reduces the net increase in agg demand.
 So, the size of the AD shift may be smaller than
the initial fiscal expansion.
 This is called the crowding-out effect.

THE INFLUENCE OF MONETARY AND FISCAL 26

 How the Crowding-Out Effect Works
A $20b increase in G initially shifts AD right by $20b
Interest P
rate MS

AD AD2
r2 AD1 3

P1
r1
MD2 $20 billion

MD1
M Y1 Y3 Y2 Y

But higher Y increases MD and r, which reduces AD.

THE INFLUENCE OF MONETARY AND FISCAL 27
 Changes in Taxes
 A tax cut increases households’ take-home pay.
 Households respond by spending a portion of this
extra income, shifting AD to the right.
 The size of the shift is affected by the multiplier
and crowding-out effects.
 Another factor: whether households perceive the
tax cut to be temporary or permanent.
 A permanent tax cut causes a bigger increase in
C – and a bigger shift in the AD curve –
than a temporary tax cut.
THE INFLUENCE OF MONETARY AND FISCAL 28
ACTIVE LEARNING 3
Exercise
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
B. If there is crowding out, will Congress need to
increase G more or less than this amount?

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ACTIVE LEARNING 3
Answers
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
Multiplier = 1/(1 – .8) = 5
Increase G by $40b
to shift agg demand by 5 x $40b = $200b.

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ACTIVE LEARNING 3
Answers
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
B. If there is crowding out, will Congress need to
increase G more or less than this amount?
Crowding out reduces the impact of G on AD.
To offset this, Congress should increase G by
a larger amount.

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 Fiscal Policy and Aggregate Supply
 Most economists believe the short-run effects of
fiscal policy mainly work through agg demand.
 But fiscal policy might also affect agg supply.
 Recall one of the Ten Principles from Chap 1:
People respond to incentives.
 A cut in the tax rate gives workers incentive to
work more, so it might increase the quantity of
g&s supplied and shift AS to the right.
 People who believe this effect is large are called
“Supply-siders.”
THE INFLUENCE OF MONETARY AND FISCAL 32
 Fiscal Policy and Aggregate Supply
 Govt purchases might affect agg supply.
Example:
 Govt increases spending on roads.
 Better roads may increase business productivity,
which increases the quantity of g&s supplied,
shifts AS to the right.
 This effect is probably more relevant in the long
run: it takes time to build the new roads and put
them into use.

THE INFLUENCE OF MONETARY AND FISCAL 33

Using Policy to Stabilize the Economy
 Since the Employment Act of 1946, economic
stabilization has been a goal of U.S. policy.
 Economists debate how active a role the govt
should take to stabilize the economy.

THE INFLUENCE OF MONETARY AND FISCAL 34

The Case for Active Stabilization Policy
 Keynes: “Animal spirits” cause waves of
pessimism and optimism among households and
firms, leading to shifts in aggregate demand and
fluctuations in output and employment.
 Also, other factors cause fluctuations, e.g.,
 booms and recessions abroad
 stock market booms and crashes
 If policymakers do nothing, these fluctuations are
destabilizing to businesses, workers, consumers.

THE INFLUENCE OF MONETARY AND FISCAL 35

The Case for Active Stabilization Policy
 Proponents of active stabilization policy
believe the govt should use policy
to reduce these fluctuations:
 When GDP falls below its natural rate,
use expansionary monetary or fiscal policy
to prevent or reduce a recession.
 When GDP rises above its natural rate,
use contractionary policy to prevent or reduce
an inflationary boom.

THE INFLUENCE OF MONETARY AND FISCAL 36

 Keynesians in the White House
1961:
John F Kennedy pushed for a
tax cut to stimulate agg demand.
Several of his economic advisors
were followers of Keynes.

2001:
George W Bush pushed for a
tax cut that helped the economy
recover from a recession that
had just begun.
THE INFLUENCE OF MONETARY AND FISCAL 37
The Case Against Active Stabilization Policy
 Monetary policy affects economy with a long lag:
 Firms make investment plans in advance,
so I takes time to respond to changes in r.
 Most economists believe it takes at least
6 months for mon policy to affect output and
employment.
 Fiscal policy also works with a long lag:
 Changes in G and T require Acts of Congress.
 The legislative process can take months or
years.

THE INFLUENCE OF MONETARY AND FISCAL 38

The Case Against Active Stabilization Policy
 Due to these long lags, critics of active policy
argue that such policies may destabilize the
economy rather than help it:
By the time the policies affect agg demand,
the economy’s condition may have changed.
 These critics contend that policymakers should
focus on long-run goals like economic growth
and low inflation.

THE INFLUENCE OF MONETARY AND FISCAL 39

 Automatic Stabilizers
 Automatic stabilizers:
changes in fiscal policy that stimulate
agg demand when economy goes into recession,
without policymakers having to take any
deliberate action

THE INFLUENCE OF MONETARY AND FISCAL 40

 Automatic Stabilizers: Examples
 The tax system
 In recession, taxes fall automatically,
which stimulates agg demand.
 Govt spending
 In recession, more people apply for public
assistance (welfare, unemployment insurance).
 Govt spending on these programs automatically
rises, which stimulates agg demand.

THE INFLUENCE OF MONETARY AND FISCAL 41

 CONCLUSION
 Policymakers need to consider all the effects of
their actions. For example,
 When Congress cuts taxes, it should consider
the short-run effects on agg demand and
employment, and the long-run effects
on saving and growth.
 When the Fed reduces the rate of money
growth, it must take into account not only the
long-run effects on inflation but the short-run
effects on output and employment.

THE INFLUENCE OF MONETARY AND FISCAL 42

CHAPTER SUMMARY

 In the theory of liquidity preference,

the interest rate adjusts to balance
the demand for money with the supply of money.
 The interest-rate effect helps explain why the
aggregate-demand curve slopes downward:
an increase in the price level raises money
demand, which raises the interest rate, which
reduces investment, which reduces the aggregate
quantity of goods & services demanded.

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CHAPTER SUMMARY

 An increase in the money supply causes the

interest rate to fall, which stimulates investment
and shifts the aggregate demand curve rightward.
 Expansionary fiscal policy – a spending increase or
tax cut – shifts aggregate demand to the right.
Contractionary fiscal policy shifts aggregate
demand to the left.

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CHAPTER SUMMARY

 When the government alters spending or taxes,

the resulting shift in aggregate demand can be
larger or smaller than the fiscal change:
 The multiplier effect tends to amplify the effects
of fiscal policy on aggregate demand.
 The crowding-out effect tends to dampen the
effects of fiscal policy on aggregate demand.

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CHAPTER SUMMARY

 Economists disagree about how actively

policymakers should try to stabilize the economy.
 Some argue that the government should use
fiscal and monetary policy to combat destabilizing
fluctuations in output and employment.
 Others argue that policy will end up destabilizing
the economy because policies work with long lags.

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