I. Introduction
A. Objectives
1. Explain how fiscal policy influences interest rates and aggregate demand
2. Explain how monetary policy influences interest rates and aggregate demand
3. Explain what determines the relative effectiveness of monetary and fiscal policy
4. Describe the Keynesian -monetarist controversy about the influence of fiscal and monetary policy on aggregate demand.
5. Explain how the mix of monetary and fiscal policy affects the composition of aggregate expenditure.
6. Explain how fiscal and monetary policy influence real GDP and the price level in both the short run and the long run.
B. Outline of the lecture
1. The role of money and interest rates in the determination of aggregate expenditures
2. The role of fiscal policy in determining aggregate demand
3. The role of monetary policy in determining aggregate demand
4. A comparison of the relative effectiveness of monetary and fiscal policy
5 The effects of monetary and fiscal policy on Real GDP and the price level
II. Money, Interest, and Aggregate Demand
(B Ch 25)
A. Real GDP (Y) and real interest rates (r) affect each other.
B. They must be determined simultaneously
c. The process can be visualized as first round and second round effects of monetary and fiscal policy.
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A. Equilibrium aggregate planned expenditure (APE) depends on:
1. the level of autonomous expenditure (A) and
2. the size of the multiplier.
APE = A * MULT
B. Investment (I) is a component of Autonomous expenditure (A).
A = (I + G + X + CA)
C. The level of investment (I) depends on the real interest rate (r).
I = f (r)
D. It follows that the equilibrium aggregate expenditure (APE) which equals real GDP (Y), also depends on the real interest rate (r)
APE = GDP = f (r)
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A. The demand for real money balances (LL) depends on the real GDP (Y)
LL = f (Y)
B. And the nominal interest rate (rn) is determined by the demand for money (LL)
rn = f (LL)
C. Hence the nominal interest rate (rn) is a function of GDP (Y)
rn = f (Y)
D. But for any given level of inflation, the real interest rate (r) is determined by the nominal interest rate (rn)
r = rn + INFRTE
E. Therefore the real interest rate (r) is determined by GDP (Y).
E. Therefore the equilibrium real interest rate (r) and the GDP (Y) will have to be determined simultaneously
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(B 25-5)
A. The equilibrium nominal interest rate (rn) is determined in the money market and
1. the equilibrium level of planned expenditure (APE) is determined in the goods market.
B. These markets are linked because:
1. the nominal interest rate (rn) determines the real interest rate (r)
a. which affects investment (I) (in the goods market) and
2. the level of expenditure (APE) affects money demand (LL) (in the money market).
C. Three diagrams can be used to show:
1. How the equilibrium nominal interest rate (rn) is determined in the money market.
a. The demand for real money balances (LL) is determined by the level of real GDP(Y)
b. The real money supply (L) is determined by the central bank.
c. the equilibrium nominal interest rate (rn) occurs at the point of intersection of the LL and L curves.
2. The Investment demand curve (II) shows how the real interest rate (r) affects the amount of investment (I).
a. An Investment Demand (II) curve
b. Assumes profit expectations are given
c. Determines equilibrium investment (I).
3. And the APE curve shows the aggregate planned expenditure at each level of real GDP (Y).
a. It shows how the amount of investment (I) affects the equilibrium level of expenditure (Y).
b. As I increases, equilibrium APE increases by a multiple.
D. The real money demand curve (LL) is drawn assuming that:
1. aggregate planned expenditure (APE) equals the same level of GDP (Y) that was assumed when the demand for money curve (LL) was drawn;
2. if it does not,
a. the money demand curve (LL) is different and
b. the interest rate does not equal r.
D. The aggregate planned expenditure curve (APE) is drawn assuming that the interest rate equals r,
1. if it does not,
a. the investment expenditure (I) is different and
b. the equilibrium level of expenditure is not (Y).
E. Thus there is one particular level of both the interest rate (rn = r) and real GDP (Y) that simultaneously gives:
1. money market equilibrium and
2. expenditure equilibrium.
F. In the goods market,
1. the higher the interest rate (rn = r),
2. the lower the GDP (Y).
G. In the money market,
1. the higher the GDP (Y),
2. the higher the interest rate (rn = r).
H. Combine these two relationships where the interest rate (r) and GDP (Y) are the same on both,
1. that is the equilibrium.
III. The IS - LM model
(B 25-5)
A. The IS-LM model allows us to see immediately how the equilibrium levels of GDP (Y) and interest rates (rn = r) are simultaneously determined.
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A. The goods market is in equilibrium when:
1. aggregate planned expenditure (APE) is equal to actual GDP (Y).
APE = Y
B. For each possible interest rate (rn = r), there is:
1. a corresponding level of autonomous spending (A) and
2. a corresponding equilibrium level of GDP (Y)
C. To construct the IS curve:
1. Vary the interest rates (r)
2. Draw the corresponding APE curves
3. Observe the corresponding equilibrium values of real GDP (Y)
4. Plot
a. the interest rates (r) on the vertical axis and
b. the levels of real GDP (Y) on the horizontal axis.
c. Label the curve the IS curve
i. (stands for Investment = Savings)
D. The IS schedule shows:
1. the different combinations of GDP (Y) and interest rates (r) at which the goods market is in equilibrium.
Y = fn (r)
E. The Slope of the IS Curve
1. The IS curve has a negative slope
a. As interest rates (r) fall,
b. equilibrium GDP (Y) rises.
2. The steepness of the slope depends on the sensitivity of autonomous spending (I and CA) to changes in real interest rates (r)
a. The flatter the investment demand curve (II), that is the more sensitive the investment demand curve (II) to the real interest rate (r)
b. the flatter will be the IS curve
E. Shifts in the IS Curve
1. The IS curve is drawn assuming everything else is constant except:
a. real interest rates (r) and
b. real GDP (Y).
2. Anything else that shifts the APE curve will also shift the IS curve.
a. e.g. an increase in government spending on goods and services (G)
i. An increase in G will result in a higher level of real GDP (Y) at each level of real interest rates (r)
b. Thus an increase in G would result in an upward shift of the IS curve.
c. Fiscal policy can alter the IS curve
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A. The money market is in equilibrium when the demand for real money balances (LL) is equal to the supply of real money balances (L).
LL = L
B. For each possible level of real GDP (Y), there is a corresponding demand for real money balances (LL).
a. and a corresponding equilibrium level of nominal interest rates (rn)
C. Construction of the LM curve
1. Start with the money market diagram
2. Vary the level of real GDP (Y)
3. Draw the corresponding LL curves
4. Observe the corresponding equilibrium values of nominal interest rates (rn)
4. Plot
a. the interest rates (r) on the vertical axis and
b. the levels of real GDP (Y) on the horizontal axis.
c. Label the curve the LM curve
i. (stands for Liquidity demand = Money supply)
C. The LM schedule shows the different combinations of real GDP (Y) and nominal interest rates (rn) at which the money market is in equilibrium.
rn = fn (Y)
1. The direction of causation for the LM curve is
[rn = f (Y)]
2. the opposite of the direction of causation for the IS curve
[ Y = f (r)]
D. The Slope of the LM Curve
1. The LM curve has a positive slope
a. As equilibrium GDP (Y) rises nominal interest rates (rn) rises.
2. The steepness of the slope depends on:
a. the sensitivity of the transactions and precautionary demands for money to changes in real GDP (Y).
b. the slope of the money demand curve (LL)
3. The more sensitive the transactions and precautionary demands are to changes in the real GDP (Y)
b. the steeper will be the LM curve
4. The flatter the money demand (LL) curve
a. the more sensitive is the demand for money curve (LL) to changes in interest rates (rn)
d. the flatter the LL curve, the flatter will be the LM curve.
E. Shifts in the LM Curve
1. The LM curve is drawn assuming everything else is constant except:
a. interest rates (r) and
b. real GDP (Y).
2. Anything else that shifts the LL curve or the L curve will also shift the LM curve.
a. e.g. an increase in the supply of real money (L) will result in a lower level of nominal interest rates (rn) at each level of real GDP (Y).
b. Thus an increase in L would result in an downward (rightward) shift of the LM curve.
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A. The IS-LM model allows us to view the market for goods and the market for money at the same time.
1. The IS curve plots points of equilibrium in the goods market
2. The LM curve plots points of equilibrium in the money market.
B. At the intersection of the IS and LM curves both markets are in equilibrium.
1. This is the equilibrium interest rate r* and
2. The equilibrium real GDP (Y*)
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C. Disequilibrium dynamics: the equilibrium is stable
1. If the interest rate (r1) were above equilibrium interest rate:
r1 > r*
a. The real GDP (Y1) produced in the goods market would be below equilibrium GDP (Y*).
b. This would result in a lower demand for real balances (LL) and the interest rate (r) would fall towards the equilibrium real interest rate (r*)
c. and the real GDP (Y) would rise toward the equilibrium (Y*)
2. The opposite would occur if the interest rate (r2) were below the equilibrium interest rate (r*)
3. If real GDP (Y1) were below equilibrium GDP (Y*)
Y1 < Y*
a. the demand for real money balance (LL) would be below the equilibrium level hence the interest rate (r) would below the equilibrium interest rate (r*)
b. This would result in a higher level of autonomous spending (A) which would increase real GDP (Y) towards the equilibrium level (Y*).
4. If the economy is temporarily out of equilibrium forces will be set in motion to restore equilibrium in both:
1. The goods market and
2. the money market
IV. Fiscal Policy and Aggregate Demand
A. An expansionary fiscal policy is one that increases aggregate demand (AD),
1. An expansionary fiscal policy is one that shifts rightward the aggregate demand curve (AD).
B. This can be illustrated in two ways
1. The multi round approach (sequentially approaching equilibrium)
2. The IS - LM approach (the simultaneous equilibrium approach)
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A. Fiscal policy can be thought of as occurring in two rounds:
1. In the first round,
a. an increase in government purchases (G) increases autonomous planned expenditure (A) ,
b. An increase in autonomous expenditure (A) increases aggregate planned expenditure (APE)
c. and raises real GDP (Y) by a multiple of the increase in G.
DELTA Y = DELTA A * MULTA
2. In the second round,
a. The higher level of GDP (Y) raises the demand for money (LL).
b. This increases the nominal interest rate (rn)
c. This increases the real interest rate (r)
c. The higher real interest rate (r) lowers investment, (I)
i. thereby decreasing autonomous expenditure.(A)
d. the reduction in A reduces APE
i. which reduces equilibrium GDP (Y).
e. The second round partially offsets the first round effect.
3. The second round effects go in the opposite direction from the first round effects
a. But they are smaller than the first round effects.
4. The net effects from an increase in government spending (G) are:
a. a higher level of GDP (Y),
b. a higher nominal interest rate, (rn)
c. a higher real interest rate, (r)
d. a lower level of investment (I).
5. This process can be illustrated as an outward shift of IS curve or an upward movement along LM curve.
a. Move to a new equilibrium real GDP (Y*) and
b. a new equilibrium interest rate (r*)
C. All fiscal policies affect the APE curve. They include:
1. changes in government purchases of goods and services (G),
2. changes in taxes (TX),
3. changes in transfer payments (TR)
D. Increasing G and TR increase equilibrium GDP (Y)
C. Increasing taxes (TX) reduces equilibrium real GDP (Y) in the goods market.
But
E. Increases in real GDP (Y) will result in increasing nominal interest rates (rn) and real interest rates (r).
1. This will result in some decreases in investment (I).
2. And a partial return of real GDP (Y) towards the old equilibrium level.
F. The net result of expansionary fiscal policy is:
1. An increase in equilibrium GDP (Y),
2. An increase in equilibrium interest rates (r) and
3. A decrease in the equilibrium level of Investment (I).
a. This was caused by the higher interest rate
b. This is called "crowding out"
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A. Assume an increase in Government spending (G) with no change in the real money supply (L)
B. This would cause an upward shift of the IS curve.
C. There would be no change in the LM curve.
D. At the new equilibrium:
1. Real GDP (Y) is higher and
2. real interest rates are higher (r)
3. Hence investment (I) is lower.
4. You have moved up along a fixed LM curve and therefore
a. The shift in equilibrium GDP (Y) is less than the shift of the IS curve
E. The increase in Government spending on goods and services (G) has "crowded out" some investment (I) spending
1. The crowding out was not complete because:
2. real GDP (Y) increased.
DELTA G > - DELTA I
3. The crowding out would be complete if:
a. the LM curve were vertical.
DELTA G = - DELTA I
3. The steeper the LM curve, the greater the crowding out.
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A. The tendency for expansionary fiscal policy to raise interest rates (r) and decrease investment (I) is called "crowding out".
1. Crowding out is generally only partial.
2. Thus the decrease in investment (I) is less than the increase in Government spending (G)
- DELTA I < DELTA G
a. so there is a net increase in A and APE.
DELTA APE = DELTA G - DELTA I
Hence DELTA APE > 0
3. Complete crowding out is unlikely, unless
a. Effect of GDP (Y) on interest rates (r) is very large and
b. Effect of interest rates (r) on investment (I) is very large.
B. An expansionary fiscal may also crowd-in investment (I);
1. Crowding in is a tendency for expansionary fiscal policy to increase investment (I).
2. There are three ways in which expansionary fiscal policy may increase investment demand (II) and thus investment (I) may be crowded in:
a. An expansionary fiscal policy may cause firms to believe the recession will be over more rapidly and thus increase the expected future profit from investment.
b. Government purchases of infrastructure may enhance the profitability of private investment and thereby increase investment.
i. e.g. roads and electric power stations
c. If the expansionary fiscal policy takes the form of reduced taxes (TX) on business profits,
i. the after-tax profitability of investment increases hence
ii. investment (I) may increase.
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C. The decrease in net exports (NX) which is the result of expansionary fiscal policy is called "international crowding out"
D. An expansionary fiscal policy causes higher interest rates (r)
1. which may cause the exchange rate to appreciate,
2. which may reduce net exports (X).
E. When interest rates (r) are higher in a country,
1. foreigners may wish to buy more of that country's bonds.
2. This increases the demand for that country's money in foreign exchange markets.
3. This increases the price of that countries money in terms of foreign currencies.
a. This makes it more expensive for foreigners to buy that country's exports (EX).
b. This also makes foreign goods cheaper, thus promoting imports (Z)
4. This decreases net exports (NX)
a. by increasing imports (Z) and
b. decreasing exports (X),
c. thereby decreasing this component of aggregate planned expenditure (APE).
F. International crowding out would reduce the effectiveness of fiscal policy.
1. Increases in Government spending (G) would be partially offset by
2. Decreases in Net Exports.
3. In the long run growth rates would be effected by the increased international debt due to lower net exports (NX).
V. Monetary Policy and Aggregate Demand
A. An expansionary monetary policy is an attempt to increase real GDP (Y)
1. by increasing the nominal money supply (M).
B. This can be illustrated in two ways
1. The multi round approach (sequentially approaching equilibrium)
2. The IS - LM approach (the simultaneous equilibrium approach)
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A. Similar to fiscal policy, an expansionary monetary policy can be described as occurring in two rounds:
B. In the first round
1. An expansionary monetary policy increases the nominal money supply (M)
2. At any given price level (P), this increases the real money supply (L)
3. and thereby lowers the equilibrium nominal interest rate (rn).
4. This lowers the real interest rate (r)
3. This leads to an increase in investment (I)
4. The increase in autonomous spending (A) will result in a multiple increase in aggregate planned expenditure (APE)
5. This will result in an increase in:
a. the equilibrium planned expenditure (APE) and
b. real GDP (Y).
6. There has been an (downward) rightward shift of the LM curve,
a. This downward shift of the LM curve results in:
i. lowering interest rates (r) and
ii. raising GDP (Y).
C. In the second round,
1. the increase in real GDP (Y) increases the demand for real money (LL),
2. which leads to a rise in the nominal interest rate (rn)
a. and the real interest rate (r).
3. This causes declines in:
a. investment (I) ,
b. Autonomous spending (A),
c. Aggregate planned expenditure (APE) and
d. equilibrium real GDP (Y).
4. In the second round
a. Spending goes in the opposite direction as the first round
b. It only partially offsets the first round effects.
5. Second round effects reduce the effect of the first round, but
a. They are not strong enough to change the direction of the first round effects of monetary policy.
6. The net effects from an increase in the nominal money supply (M) are:
a. a higher interest rate, (r)
b. lower investment, (I) and
c. lower real GDP (Y).
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C. The international effects of an expansionary monetary policy are:
1. An increase in the nominal money supply (M) lowers the nominal interest rate (rn)
2. The lower nominal interest rate (rn) encourages foreigners to:
a. refuse to buy more of the countries bonds and to
b. try to sell their holdings of the country's bonds.
3. This reduces the foreign demand for the country's money
4. This lowers the price of the country's money in foreign exchange markets. (the foreign exchange rate).
a. This reduces the price of the countries exports and
b. makes imported goods more expensive.
6 The decline in the international value of a countries' money:
a. Increases the county's exports (X) and
b. Reduces its imports (Z),
c. thereby increasing net exports (NX)
7. An increase in Net Exports (NX)
a. reduces aggregate planned expenditure (APE)
b. and equilibrium expenditure and real GDP (Y).
8. Hence, the international effect of an expansionary monetary policy:
a. reinforces the domestic effect of monetary policy
b. by further increasing aggregate demand.
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A. Assume that the central bank increases the supply of nominal money (M).
1. But there is no change in the price level (P).
2. This will also increase the real money supply (L)
B. This would cause an downward (rightward) shift of the LM curve.
C. There would be no change in the IS curve.
D. At the new equilibrium:
1. Real GDP (Y) is higher and
2. real interest rates are lower (r)
3. Hence investment (I) is higher.
4. You have moved down along a fixed IS curve and therefore
a. The shift in equilibrium interest rate (r) is less than the shift if the LM curve
b. This is because the increase in real GDP (Y) has increased the demand for real money balances (LL).
E. Unlike expansionary fiscal policy, the increase in the money supply (L) has not "crowded out" investment (I) spending
a. Expansionary monetary policies promote Investment spending (I)
i. by lowering interest rates (r)
VI. The Relative Effectiveness of Fiscal and Monetary Policy
A. Economists and policy makers were once concerned about which was more effective, in altering real GDP
1. monetary policy or
2. fiscal policy.
B. Classical economists favored monetary policy
C. Keynesian economists favored fiscal policy
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(25-6)
A. At any given price level (P), the effectiveness of fiscal policy is given by:
1. the magnitude of the change in real GDP (Y) per unit increase in government purchases (G),
Effectiveness = DELTA GDP / DELTA G
2. after changes in interest rates (r) and exchange rates have been accounted for.
B. This depends on two factors:
1. the sensitivity of investment (I) to the interest rate (r) and
a. the flatter the II curve, the more sensitive is investment spending (I) to real interest rates (r)
b. the flatter the II curve, the flatter the IS curve.
2. the sensitivity of money demand (LL) to the interest rate (r).
(Slope of LL curve)
C. The more sensitive investment demand (II) is to the interest rate, (r) the smaller the impact of fiscal policy.
1. the flatter the II curve,
a. the bigger the crowding out effect on Investment (I) of an induced change in interest rates (r).
D. The flatter the IS curve,
1. the smaller the impact of expansionary fiscal policy on real GDP (Y).
D. Rising real GDP (Y) shifts the LL curve to the left. Thus increasing interest rates (r).
1. The greater the interest rate (r) sensitivity of investment (I) :
a. the greater the crowding out of investment (I).
E. The more sensitive the quantity of money demanded (LL) to the interest rate (r), the greater the impact of fiscal policy
1. The flatter the slope of LL curve, the smaller the change in real interest rates (r) needed to restore equilibrium
a. after a given shift of the LL curve due to:
i. an increase in real GDP (Y).
2. The flatter the slope of the LL curve, the flatter the slope of the IS curve
a. and the smaller the change in interest rates (r) and
b. the less the crowding out of investment (I)
3. The greater interest rate sensitivity of money demand (LL) means that the interest rate need change only a little
a. to equilibrate the demand for money
i. (which shifts due to change in real GDP (Y) with the (fixed) supply of real money (L).
F. The smaller the impact of an increase in GDP (Y) on the interest rate (r).
1. The less will be the crowding out and
2. the greater the impact of fiscal policy.
E. Hence Fiscal policy is more effective
1. The steeper the IS curve and
2. The flatter the LM curves,
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A. At any given price level (P), the effectiveness of monetary policy is measured by:
1. the change in real GDP (Y) resulting from a given change in the nominal money supply (M)
DELTA Y / DELTA M
2. After changes in interest rates (r) and exchange rates have been taken into account.
B. At any given price level (P)
1. a proportional change in the nominal money supply (M) is equal to
2. the proportional change in the real money supply (L).
% DELTA M = % DELTA L
B. The effectiveness of monetary policy depends on the same two factors that determine the effectiveness of fiscal policy;
1. the sensitivity of investment (I) to the interest rate (r) or
a. The slope of the investment demand II curve
i. (or the slope of the IS curve)
2. the sensitivity of money demand (LL) to the interest rate (r).
a. The slope of the LL curve
i. or the slope of the LM curve
C. The more sensitive investment demand (II) to the real interest rate (r), the greater the impact of monetary policy.
1. In this case a greater interest rate sensitivity of investment demand (II) means that:
a. The II curve is relatively flat
i. (the IS curve is relatively flat)
b. The interest rate (r) change resulting from a change in the real money supply (L)
i. Has a large effect on Investment (I)
c. Hence a large effect on aggregate planned expenditure (APE) and real GDP (Y).
2. Flatter the IS curve, the more effective is monetary policy
D. The more sensitive the quantity of money demanded (LL) to the interest rate (r),
1. the smaller the impact of monetary policy.
E. The greater interest rate sensitivity of money demand (LL) means that the interest rate (r) need change only a little to accommodate the change in the supply of money (L)
a. This means the money demand curve (LL) is relatively flat)
b. This means that the LM curve is relatively flat
2. A smaller the change in the interest rate, (r) means a smaller effect of a change in the nominal money supply (M) on investment demand (I).
a. for any given investment demand (II) curve
3. The smaller the impact on investment demand (I), the smaller the impact of a change in the nominal money supply (M) on:
a. aggregate planned expenditure (APE) and
b. equilibrium real GDP (Y).
4. Hence the less effective will be monetary policy.
E. To summarize, Monetary policy is more effective
1. The flatter the investment demand (II) and IS curve and
2. The steeper the money demand (LL) and LM curves,
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A. Sensitivity increases with substitutability
B. Sensitivity of the investment demand curve (II). (Slope of II curve and IS curve)
1. Investment (I) is the accumulation of capital goods (K)
2. Interest rates (r) represent the opportunity cost of buying capital goods
3. The more easily other factors can be substituted for capital,(K)
a. the more Investment (I) will respond to increases (or decreases) in real interest rates (r)
b. Hence, the flatter is the II curve
C. Sensitivity of the demand for money curve (LL). (Slope of LL curve and the LM curve)
1. Holding wealth as money is an alternative to holding wealth in the form of other financial assets (e.g. bonds).
a. Money is held for the following purposes (motives):
i. transactions,
ii. precautionary and
iii. speculative
2. The nominal interest rate (rn) is the opportunity cost of holding wealth in the form of money
3. The more easily that other financial assets (e.g. bonds) can be substituted for money in achieving the purposes of holding money,
a. the more money demand (LL) will respond to changes in nominal interest rates (r).
a. The flatter the LL and LM curves
4. The LL and LM curves will be flatter as other assets become more liquid.
a. Other assets become more liquid if they can be converted into money
i. More quickly
ii. More conveniently
iii. more cheaply
VII. The Keynesian-Monetarist Controversy
A. The Keynesian-Monetarist controversy was a dispute between two groups of economists.
1. Keynesian economists, regarded the economy as
a. Inherently unstable and
b. In need of active government intervention,
c. They assigned high importance to fiscal policy and low importance to monetary policy
2. Monetarist economists, regarded the economy as
a. inherently stable and
b. believed most of the fluctuations in aggregate demand are due to changes in the quantity of money (M).
c. They assigned lower importance to fiscal policy and higher importance to monetary policy
B. Part of the Keynesian-Monetarist controversy was over the relative effectiveness of fiscal and monetary policy.
C. There were three positions:
1. The extreme Keynesians
2. The extreme Monetarists
3. Everyone else
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A. The Extreme Keynesians suggested that
1. A change in the money supply (M) has no effect on real GDP (Y) and
2. A change in government spending (G) has a large effect on real GDP (Y).
B. They believed that fiscal policy would be effective (and monetary policy would be ineffective) because:
1. The interest rates (r) had almost no effect on investment (I)
a. the investment demand curve (II) is vertical
b. Thus, the IS curve is also vertical
2. Hence, lowering interest rates (rn) through monetary policy would not stimulate investment (I) and
c. fiscal policy would not be weakened by crowding out because:
i. if real interest rates (r) were raised as a result of rising GDP,
ii. there would be no crowding out because:
iii. investment (I) was not sensitive to interest rates (rn).
and\or
4. The extreme Keynesians believed that monetary policy would be ineffective and fiscal policy would not suffer from crowding out because:
a.The quantity of money demanded (LL) was infinitely sensitive to the interest rate (rn)
i. the demand for money curve (LL) is horizontal.
ii. Hence the LM curve is horizontal
b. Monetary policy would be ineffective because increases in the money supply (M) would not alter nominal interest rates (rn).
c. Fiscal policy would be totally effective because
i. increases in GDP (Y) would not alter nominal interest rates (rn)
ii. Hence there would be no crowding out of investment (I).
C. If either of the IS curve is vertical -- or the LM curve is horizontal.
1. The extreme Keynesians would be correct.
2. Monetary policy would be totally ineffective and
3. Fiscal policy would be totally effective (no crowding out).
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A. The Extreme monetarists asserted that:
1. Investment demand (II) was infinitely sensitive to the real interest rate (r)
a. The investment demand curve (II) was almost horizontal
ii. Hence the IS curve was almost horizontal
2. Monetary policy would be very effective because:
a. even the slightest reduction in real interest rates (r) would bring forth a massive increase in investment (I)
b. This would bring about a large increase in real GDP (Y)
3. But fiscal policy would be totally ineffective because:
a. even the slightest increase in interest rates (r), which is the result of expansionary fiscal policy would result in:
i. large reductions in investment (I) (full crowding out)
b. And thus an increase in government spending (G) would have no net effect on:
i. aggregate planned expenditure (APE) or
ii. equilibrium GDP (Y).
4. In summary :
a. There would be very big response of investment (I) to change in the nominal money supply (M)
b. However, a change in Government spending (G) would be fully offset by a change in investment (I).
DELTA G = - DELTA I
and\or
B. Extreme monetarists believed that monetary policy would be effective because the interest rate (r) had almost no effect on the quantity of money demanded (LL)
1. The money demand curve (LL) is almost vertical.
2. Hence the LM curve is almost vertical
3. Any change in the money supply (M) would have a very large effect on nominal interest rates (rn)
C. Extreme monetarists believed that fiscal policy would have no effect because:
1. Any change in money demand (LL) resulting from an increase in real GDP (Y) caused by an increase in government spending (G)
a. would have a very large effect on interest rates (rn).
2. This would crowd out investment (I)
3.. In this case, changes in fiscal policy have no effect on real GDP (Y).
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A. The majority of economists have adopted an intermediate position. They hold that:
1. Neither the investment demand curve (II) nor money demand (LL) curve are:
i. vertical or
ii horizontal.
2. Hence neither the I-S curve nor the L-M curve are:
i. vertical or
ii horizontal.
3. Both II curve and the LL curve are negatively sloped.
4. Hence the IS curve is negatively sloped and the LM curve is positively sloped.
5. Both monetary and fiscal policy will change:
a. interest rates (r) and
b. real GDP (Y).
6. Thus, both monetary and fiscal policy can effect aggregate demand.
7. For the US the statistical evidence supports the intermediate position.
VIII. The monetary-fiscal policy mix and economic growth
A. The Effect of the Policy mix on investment (I) and growth:
1. It makes a difference whether changes in income and prices have been achieved by:
a. monetary policy or
b. fiscal policy.
B. Expansionary fiscal policy boosts government spending (G) and consumption (C)
1. but lowers investment (I);
a. There is partial crowding out of investment (I)
C. Expansionary monetary policy boosts consumption (I) and investment (I)
a. while not changing government spending (G).
b. Investment (I) is increased not decreased
D. Thus by affecting investment (I) differently, the choice of which economic tool to use has long-run consequences for the economy.
1. Expansionary fiscal policy reduces investment (I)
2. Contractionary monetary policy reduces investment (I)
3. That reduces the rate of capital formation. (K)
4. That reduces the growth rate of potential real GDP (YP)
a. or the rightward shift of the LAS curve.
IX. Real GDP and the Price Level
(B 26 - 1)
A. The effects of monetary and fiscal policy calculated so far assume:
1. a constant price level (P).
B. This is an unrealistic assumption because:
1. Both expansionary fiscal and expansionary monetary policy shift the aggregate demand curve (AD) to the right.
C. The magnitude of the horizontal shift in the AD curve from fiscal policy and monetary equals:
1. the change in real GDP (Y) obtained using the
a. IS curve and LM curve
2. Every point on the AD curve corresponds to an equilibrium of the IS and LM curves.
a. For every price level (P), there is a corresponding equilibrium level of:
i. GDP (Y) and
ii. interest rate (r).
iii. The interest rate (r) is not shown on the AD-AS diagram but it must be kept in mind
3. The AD curve can be generated by altering the price level (P).
a. holding the nominal money supply (M) constant.
4. As the price level (P) rises, the real money supply (L) falls
i. This shifts up (leftward) the LM curve
ii. That lowers the equilibrium real GDP (Y)
iii. That raises the equilibrium interest rate (r)
5. Autonomous consumption (CA) falls due to reduced real balances.
a. This shifts downward (rightward) the IS curve
b. This lowers the equilibrium real GDP (Y)
c. This lowers the equilibrium rate of interest (r)
6. Because of the interest rate effect and the real balances effect, a higher price level (P) reduces real GDP (Y).
a. Hence the AD curve has a negative slope
b. The Law of Aggregate Demand
7. The effect of a rising price level (P) on the real interest rate (r) is on balance to raise it.
a. The supply of real money balances (L) is reduced by more than the demand for real money balances (LL).
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A. In the short run expansionary fiscal policy and monetary policy shifts the aggregate demand curve (AD) to the right
1. This increases both the price level (P) and real GDP (Y)
a. The economy moves up along its short-run aggregate supply curve (SAS) curve.
3. A higher price level (P) reduces the real supply of money (L)
4. This raises interest rates (r)
5. It reduces investment (I)
6. This moderates the increase in real GDP (Y).
B. The change in real GDP (Y) can be divided into
1. a policy effect and
2. a price effect
C. The policy effect is what would happen if prices remained constant
D. The price effect is a subtraction from the policy effect.
1. It is the result of the price rise which was triggered by
2. the increase in aggregate demand.
DELTA Y = POLICY EFFECT ON Y - PRICE EFFECT ON Y
E. The price effect will be less than the policy effect
F. In the short run, monetary policy and fiscal policy will alter:
a. real GDP (Y) and
b. the price level (P)
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A. The long-run effects of fiscal and monetary policy depend on the initial state of the economy.
B. We can consider three possible cases:
1. Real GDP (Y) is below potential GDP (YP)
a. There is a business slump
b. Unemployment (U) is above the natural rate of unemployment (U*)
Y < YP
U > U*
2. Real GDP (Y) is above potential GDP (YP)
a. A business boom
b. Unemployment (U) is below the natural rate of unemployment (U*)
Y > YP
U < U*
3. Real GDP (Y) is equal to potential GDP (YP)
a. A long run equilibrium
b. Unemployment (U) is equal to the natural rate of unemployment (U*)
Y = YP
U = U*
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A. If the economy initially had unemployment (U) above the natural rate (U*),
U > U*
1. And real GDP (Y) is below its long run potential level (YP).
Y < YP
B. An expansionary fiscal policy, or an expansionary monetary policy
a. Shifts the AD curve to the right
b. The economy moves up the SAS curve
c. towards the LAS curve and
d. permanently increases:
i. real GDP (Y) and
ii. the price level (P).
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A. If the economy initially was at the natural rate of unemployment,
U = U*
1. Real GDP (Y) equals long run potential GDP (YP)
Y = YP
B. An expansionary fiscal or monetary policy shifts the aggregate demand (AD) curve to the right. (to AD').
1. This would result in a movement of the economy upward
a. along the short run aggregate supply (SAS) curve.
2. Prices (P) would rise and
3. GDP (Y) would be above the full employment level (YP).
Y > YP
4. In time this would lead to wage increases.
5. Wage increases would shift up the SAS curve to SAS'.
a. The economy would move up along the new AD curve (AD').
b. Prices (P) would rise and
c. real GDP (Y) would fall.
7. The SAS curve would continue to shift
8. And the economy would continue to move along the new AD curve (AD') until
a. real GDP (Y) fell to the potential level (YP).
Y = YP
b. This corresponds to full employment (U = U*) in the labor market.
D. The long run changes in real GDP (Y) can be decomposed into three effects:
1. The policy effect (wages and prices are constant)
2. The price effect (only wages are constant)
3. The long-run adjustment effect (wages also change)
E. The policy effect is what would happen if wages and prices remained constant
F. The price effect is a subtraction from the policy effect
1. It is caused by the price (P) rise which was triggered by
a. the increase in aggregate demand (AD).
G. The long run adjustment effect will equal
1. the difference between the policy effect and the price effect.
LRA EFFECT = - (POLICY EFFECT - PRICE EFFECT)
2. It is caused by the increase in wages triggered by
a. The increase in aggregate demand (AD).
H. The net effect of expansionary fiscal and monetary policy can be decomposed as follows:
1. The policy effect increases real GDP (Y)
2. the price effect reduces real GDP (Y)
3. The long run adjustment effect also reduces real GDP (Y)
a. NET EFFECT = POLICY EFFECT on Y
- PRICE EFFECT on Y - LONG RUN ADJUSTMENT EFFECT on Y
4. All three effects raise the price level (P)
X Summary of the lecture
Key concepts
1. Crowding in
2. Crowding out (Su lan at)
3. International crowding out
4. I-S curve (cac duong bieu thi IS)
5. Keynesian
6. L-M curve (cac duong bieu thi LM)
7. Liquidity trap
8. Monetarist
Review Questions
1. Why are money markets linked to goods markets?
2. What are the first round effects of an increase in government purchases of goods and services (G)?
3. What are the second round effects of an increase in government purchases of goods and services (G)?
4. What role does the foreign exchange rate play in influencing aggregate expenditure when there is an expansionary fiscal policy?
5. What are the first round effects of an expansionary monetary policy?
6. What are the second round effects of an expansionary monetary policy?
7. What role does the foreign exchange rate play in influencing aggregate expenditure when there is an expansionary fiscal policy?
8. What factors determine the relative effectiveness of monetary and fiscal policy?
9. Under what conditions would fiscal policy be more effective than monetary policy in increasing GDP (Y)?
10. What were the hypotheses of the Extreme Keynesians?
11. What were the hypotheses of the Extreme Monetarists?
12. How does expansionary monetary policy differ from expansionary fiscal policy in its effect on investment (I) ?
13. What will be the short-run effect of an expansionary monetary policy on the level of GDP (Y) and the price level (P)?
14. What will be the long-run effect of an expansionary monetary policy on the level of GDP (Y) and the price level (P)?