Chapter 35
!
Monetary Policy
Fiscal Policy
and
Aggregate Demand
Key Terms
theory of liquidity preference	

fiscal polices	

multiplier effect	

crowding-out effect	

automatic stabilizers...
Economic Cycle
Aggregate Demand
Wealth Effect	

Interest-Rate Effect	

Exchange-Rate Effect
John Maynard Keynes	

(1883 - 1946)	

!
Father of Macroeconomics	

!
The GeneralTheory of 	

Employment, 	

Interest and M...
Theory of Liquidity
Preference
Interest rates adjust to
bring money supply and
money demanded into
balance
Interest Rates
Nominal = Real + Inflation	

!
If inflation is zero, then
nominal = real
Money Supply
Discount Rate	

Bond Market	

Reserve Ratio
Interest	

Rate
Quantity of MoneyMD1
Money Market
MD2
r1
r2
Money	

Supply
Money	

Demand
Quantity fixed
by the Central
Ban...
Liquidity Theory
1. Money Supply is fixed by central bank with
policy tools (Debt Instrument Market, Discount
Rate, Reserve...
Interest	

Rate
Quantity of Money
Money Market
r2
Money	

Supply
Money	

Demand
Quantity fixed
by the Central
Bank
r1
r3
Money	

Demand
Interest	

Rate
Quantity of Money
Money Market
r
Money	

Supply
r1
r3
Interest	

Rate
1. Price level increases	

2. Increases demand for money	

3. Increases interest rate	

4. Reduces quantit...
Fiscal Policies
Level of government
spending and taxing
Multiplier Effect
Additional shifts in
aggregate demand due to
expansionary government
spending
Marginal Propensity to Consume
MPC
New income = spend + save	

How much do you spend?	

75 percent	

Then you will be savi...
Marginal Propensity to Consume
plus
Marginal Propensity to Save
equals one
!
MPC + MPS = 1
1- MPS = MPC
1- MPC = MPS
Earn Spend Total Spending
1 100.0 75.0 75.0
2 75.0 56.3 131.3
3 56.3 42.2 173.4
4 42.2 31.6 205.1
5 31.6 23.7 228.8
6 23.7...
MPC MPS Total Spending
1.00 0.00 infinite
0.90 0.10 10.00
0.80 0.20 5.00
0.75 0.25 4.00
0.60 0.40 2.50
0.50 0.50 2.00
0.40 ...
Multiplier Effect
1.Works with C, I, G, and
NX	

2. Goes both ways
Where does the money
come from?
Tax	

Borrow	

Reduces Income	

Increases interest
Crowding-Out can be
larger than the
Multiplier
Aggregate Demand shifts
left
Crowding-out Effect
Offsetting aggregate
demand when fiscal
expansion raises interest
rates and reduces spending
Price	

Level
Quantity of Output
PL
Y3 Y1 Y2
Government Spending	

Multiplier Effect
Government Spending	

Crowding-Out Ef...
Automatic Stabilizers
Changes in fiscal policy that
stimulate aggregate demand
when the economy goes
into a recession
Physical Financial Human Intellectual Cultural Total
Saudi
Arabia
Qatar
U.A. E.
Jordan
Kuwait
Iraq
Egypt
Capital Analysis ...
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Eco 202 ch 35 monetary fiscal aggregate demand

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Eco 202 ch 35 monetary fiscal aggregate demand

  1. 1. Chapter 35 ! Monetary Policy Fiscal Policy and Aggregate Demand
  2. 2. Key Terms theory of liquidity preference fiscal polices multiplier effect crowding-out effect automatic stabilizers !
  3. 3. Economic Cycle
  4. 4. Aggregate Demand Wealth Effect Interest-Rate Effect Exchange-Rate Effect
  5. 5. John Maynard Keynes (1883 - 1946) ! Father of Macroeconomics ! The GeneralTheory of Employment, Interest and Money ! The ideas of economists and political philosophers are more powerful than commonly understood; indeed the world is ruled by little else.
  6. 6. Theory of Liquidity Preference Interest rates adjust to bring money supply and money demanded into balance
  7. 7. Interest Rates Nominal = Real + Inflation ! If inflation is zero, then nominal = real
  8. 8. Money Supply Discount Rate Bond Market Reserve Ratio
  9. 9. Interest Rate Quantity of MoneyMD1 Money Market MD2 r1 r2 Money Supply Money Demand Quantity fixed by the Central Bank Equilibrium Interest Rate
  10. 10. Liquidity Theory 1. Money Supply is fixed by central bank with policy tools (Debt Instrument Market, Discount Rate, Reserve Requirement) 2. Money Demand - Liquidity - Interest rate is the opportunity cost of holding money. 3. Equilibrium pressures
  11. 11. Interest Rate Quantity of Money Money Market r2 Money Supply Money Demand Quantity fixed by the Central Bank r1 r3
  12. 12. Money Demand Interest Rate Quantity of Money Money Market r Money Supply r1 r3
  13. 13. Interest Rate 1. Price level increases 2. Increases demand for money 3. Increases interest rate 4. Reduces quantity demand of output Money Market r2 Money Supply Money Demand Quantity fixed by the Central Bank r1 Price Level P2 Aggregate Demand OutputY2 P1 Y1 Aggregate Demand
  14. 14. Fiscal Policies Level of government spending and taxing
  15. 15. Multiplier Effect Additional shifts in aggregate demand due to expansionary government spending
  16. 16. Marginal Propensity to Consume MPC New income = spend + save How much do you spend? 75 percent Then you will be saving 25 percent
  17. 17. Marginal Propensity to Consume plus Marginal Propensity to Save equals one ! MPC + MPS = 1 1- MPS = MPC 1- MPC = MPS
  18. 18. Earn Spend Total Spending 1 100.0 75.0 75.0 2 75.0 56.3 131.3 3 56.3 42.2 173.4 4 42.2 31.6 205.1 5 31.6 23.7 228.8 6 23.7 17.8 246.6 7 17.8 13.3 260.0 8 13.3 10.0 270.0 9 10.0 7.5 277.5 10 7.5 5.6 283.1 11 5.6 4.2 287.3 Multiplier ! 1/(1-MPC) ! Remember 1-MPC = MPS Therefore Multiplier also 1/MPS
  19. 19. MPC MPS Total Spending 1.00 0.00 infinite 0.90 0.10 10.00 0.80 0.20 5.00 0.75 0.25 4.00 0.60 0.40 2.50 0.50 0.50 2.00 0.40 0.60 1.67 0.30 0.70 1.43 0.25 0.75 1.33 0.10 0.90 1.11 0.50 0.50 2.00 Multiplier ! 1/(1-MPC) ! Remember 1-MPC = MPS ! Therefore Multiplier also 1/MPS
  20. 20. Multiplier Effect 1.Works with C, I, G, and NX 2. Goes both ways
  21. 21. Where does the money come from? Tax Borrow Reduces Income Increases interest
  22. 22. Crowding-Out can be larger than the Multiplier Aggregate Demand shifts left
  23. 23. Crowding-out Effect Offsetting aggregate demand when fiscal expansion raises interest rates and reduces spending
  24. 24. Price Level Quantity of Output PL Y3 Y1 Y2 Government Spending Multiplier Effect Government Spending Crowding-Out Effect Taxes & Borrowing
  25. 25. Automatic Stabilizers Changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession
  26. 26. Physical Financial Human Intellectual Cultural Total Saudi Arabia Qatar U.A. E. Jordan Kuwait Iraq Egypt Capital Analysis Scale 1-10 each category 1=lowest, 10=highest

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