Lecture 9 monetary and fiscal policy

Macroeconomics
lecture 9


Monetary
and

Fiscal Policy

Chapter 34


Lecture Objectives

1.
2.
3.
4.
5.

Theory of liquidity preference
Monetary policy
Fiscal policy
Multiplier effect
Crowding-out effect

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Synergy of the monetary and fiscal policy
Case study

Aggregate Demand
M Value

Price
Level

P1

P2
Aggregate
demand

0

Y1

Y2

Quantity of
Output


The Money Market and Aggregate Demand
(a) The Money Market
Interest Rate

(b) Commodity & service Market
Price

Money supply

Level

2. …increases the

1. An increase in the price

demand for money…

level…
P2

r2
Money demand at
price level P2, MD2

Aggregate demand

P1

r1

Money demand at price level P1,
MD1

0

Quantity fixed by the CB

Quantity of

0

Y2

Quantity
of Output

Money

3. …which increases the equilibrium rate…

Y1

4. …which in turn reduces the quantity of
goods and services demanded.


The Theory of Liquidity Preference

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


Equilibrium in the Money Market
Interest
Rate
Money
supply

r1
Equilibrium interest
rate

r2

Money
demand

0

M

d
1

Quantity fixed
by the CB

M

d
2

Quantity of
Money


Monetary Policy

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


Regulated Money Supply
(a) The Money Market

Interest Rate

Money supply,
MS1

(b) The Aggregate-Demand Curve

MS2

3. …which increases the

Price Level

quantity of goods and
services demanded at a

1. When the CB

given price level.

increases the
money supply…
P
r1

r2

AD2

Aggregate demand, AD1

0

Quantity

2. …the equilibrium interest
rate falls…

of Money

0

Y1

Y2

Quantity

of Output


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


Weaknesses of Monetary Policy

◦Difficult to predict time-lag between action and outcome
◦Weak when trying to stimulate economic activity.


The Fiscal Policy

Income tax

Soc. Security

Business tax

Health

Sales Tax

Education

Excise duty

Defence

Non-tax rev.
Other

Public serv’s
Public debt

$
$

interest
Other

Revenue

Outlays

BUDGET


Fiscal policy - Measures

◦Government spendings, led to effects:

◦The multiplier effect
◦The crowding-out effect
◦Taxation


Multiplier Effect
Price
2. …but the multiplier effect can amplify the shift in aggregate

Level

demand.

$20 billion

AD3
1. An increase in government purchases of
$20 billion initially increases aggregate
demand by $20 billion…

0

AD2

Aggregate demand, AD1

Quantity
of Output


Multiplier Effect

◦The formula for the multiplier is:
Multiplier = 1/(1 - MPC)

◦MPC: marginal propensity to consume - fraction of extra income that a household
consumes rather than saves.


The Crowding-Out Effect

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


The Crowding-Out Effect
(a) The Money Market

(b) The Shift in Aggregate Demand
4. …which in turn partly

Interest Rate

offsets the initial increase in

Price

aggregate demand.

Level

Money
supply
2. …the increase in

spending increases money
r2

demand…

$20 billion

AD2

r1
MD2

AD3
Aggregate demand, AD1

Money demand, MD1
0

Quantity fixed by the
Fed

3. …which increases the equilibrium interest rate…

Quantity of

0

Quantity of Output

Money
1. When an increase in government purchases increases aggregate
demand…


Changes in Taxes

The extent of effects on aggregate demand subject to:
Multiplier effect
Crowding-out effect.
Households’ perceptions


Strengths of Fiscal Policy

◦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

Weaknesses of Fiscal Policy

◦Uncertainty of its outcomes
◦Timing/ Implementation lags
◦Political sensitivity
◦“Crowding-out” effect of budget deficit


CASE STUDY
VN stabilisation policy in 2019?
Background: at closure of 2018

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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?

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Lecture Review

◦Theory of liquidity preference
◦Monetary policy
◦Fiscal policy
◦Synergy of monetary and fiscal policy
◦Case study