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- 1. Monetary and Fiscal Policies
- 2. Short-Run Economic Fluctuation <ul><li>Economic activity fluctuates from year to year. </li></ul><ul><li>A recession is a period of declining real incomes, and rising unemployment. </li></ul><ul><li>A depression is a severe recession. </li></ul><ul><ul><li>Fluctuations in the economy are often called the business cycle. </li></ul></ul>
- 3. Basic Model <ul><li>Two variables are used to develop a model to analyze the short-run fluctuations. </li></ul><ul><ul><li>The economy ’ s output of goods and services measured by real GDP. </li></ul></ul><ul><ul><li>The overall price level measured by the CPI or the GDP deflator. </li></ul></ul><ul><li>The Basic Model of Aggregate Demand and Aggregate Supply </li></ul><ul><ul><li>Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend. </li></ul></ul>
- 4. Aggregate Demand and Supply Curves <ul><ul><li>The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. </li></ul></ul><ul><ul><li>The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level. </li></ul></ul>
- 5. Aggregate Demand and Aggregate Supply Quantity of Output Price Level 0 Aggregate supply Aggregate demand Equilibrium output Equilibrium price level
- 6. Aggregate Demand Curve <ul><li>The four components of GDP ( Y ) contribute to the aggregate demand for goods and services. </li></ul><ul><li>Y = C + I + G + NX </li></ul>
- 7. The Aggregate-Demand Curve... Quantity of Output Price Level 0 Aggregate demand P Y Y 2 P 2 1. A decrease in the price level . . . 2. . . . increases the quantity of goods and services demanded.
- 8. Shifts <ul><li>Shifts arising from </li></ul><ul><ul><li>Consumption </li></ul></ul><ul><ul><li>Investment </li></ul></ul><ul><ul><li>Government Purchases </li></ul></ul><ul><ul><li>Net Exports </li></ul></ul>
- 9. <ul><li>Demand Curve Shifts </li></ul>0 P 1 Y 1 Quantity of Output Price Level Aggregate demand, D 1 D 2 Y 2
- 10. Aggregate Supply Curve <ul><li>In the long run, the aggregate-supply curve is vertical . </li></ul><ul><li>In the short run, the aggregate-supply curve is upward sloping . </li></ul>
- 11. The Long-Run Aggregate-Supply Curve Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P 2 1. A change in the price level . . . 2. . . . does not affect the quantity of goods and services supplied in the long run. P
- 12. Long-Run Aggregate Supply Curve <ul><li>The Long-Run Aggregate-Supply Curve </li></ul><ul><ul><li>The long-run aggregate-supply curve is vertical at the natural rate of output. </li></ul></ul><ul><ul><li>This level of production is also referred to as potential output or full-employment output. </li></ul></ul><ul><li>Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve. </li></ul><ul><li>The shifts may be categorized according to the various factors in the classical model that affect output. </li></ul>
- 13. Shifts <ul><li>Shifts arising </li></ul><ul><ul><li>Labor </li></ul></ul><ul><ul><li>Capital </li></ul></ul><ul><ul><li>Natural Resources </li></ul></ul><ul><ul><li>Technological Knowledge </li></ul></ul>
- 14. Long-Run Growth and Inflation Quantity of Output Price Level 0 Y 1980 AD 1980 AD 1990 Aggregate Demand, AD 2000 Long-run aggregate supply, LRAS 1980 Y 1990 LRAS 1990 Y 2000 LRAS 2000 P 1980 1. In the long run, technological progress shifts long-run aggregate supply . . . 4. . . . and ongoing inflation. 3. . . . leading to growth in output . . . P 1990 P 2000 2. . . . and growth in the money supply shifts aggregate demand . . .
- 15. Short-Run Aggregate Supply Curve <ul><li>Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends. </li></ul><ul><li>In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied. </li></ul><ul><li>A decrease in the level of prices tends to reduce the quantity of goods and services supplied. </li></ul>
- 16. The Short-Run Aggregate-Supply Curve Quantity of Output Price Level 0 Short-run aggregate supply 1. A decrease in the price level . . . 2. . . . reduces the quantity of goods and services supplied in the short run. Y P Y 2 P 2
- 17. The Long-Run Equilibrium Quantity of Output Price Level 0 Natural rate of output Short-run aggregate supply Long-run aggregate supply Aggregate demand A Equilibrium price
- 18. Two Causes of Economic Fluctuation <ul><li>Shifts in Aggregate Demand </li></ul><ul><ul><li>In the short run, shifts in aggregate demand cause fluctuations in the economy ’ s output of goods and services. </li></ul></ul><ul><ul><li>In the long run, shifts in aggregate demand affect the overall price level but do not affect output. </li></ul></ul><ul><li>An Adverse Shift in Aggregate Supply </li></ul><ul><ul><li>A decrease in one of the determinants of aggregate supply shifts the curve to the left: </li></ul></ul><ul><ul><ul><li>Output falls below the natural rate of employment. </li></ul></ul></ul><ul><ul><ul><li>Unemployment rises. </li></ul></ul></ul><ul><ul><ul><li>The price level rises </li></ul></ul></ul>
- 19. A Contraction in Aggregate Demand Quantity of Output Price Level 0 Long-run aggregate supply Short-run aggregate supply, AS Aggregate demand, AD A P Y AD 2 AS 2 1. A decrease in aggregate demand . . . 2. . . . causes output to fall in the short run . . . 3. . . . but over time, the short-run aggregate-supply curve shifts . . . 4. . . . and output returns to its natural rate. C P 3 B P 2 Y 2
- 20. An Adverse Shift in Aggregate Supply Quantity of Output Price Level 0 Long-run aggregate supply Aggregate demand 3. . . . and the price level to rise. 2. . . . causes output to fall . . . 1. An adverse shift in the short- run aggregate-supply curve . . . Short-run aggregate supply, AS Y A P AS 2 B Y 2 P 2
- 21. Stagflation <ul><li>Stagflation </li></ul><ul><ul><li>Adverse shifts in aggregate supply cause stagflation — a period of recession and inflation. </li></ul></ul><ul><ul><ul><li>Output falls and prices rise. </li></ul></ul></ul><ul><ul><ul><li>Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously. </li></ul></ul></ul>
- 22. Policy Responses to Recession <ul><li>Policy Responses to Recession </li></ul><ul><ul><li>Policymakers may respond to a recession in one of the following ways: </li></ul></ul><ul><ul><ul><li>Do nothing and wait for prices and wages to adjust. </li></ul></ul></ul><ul><ul><ul><li>Take action to increase aggregate demand by using monetary and fiscal policy. </li></ul></ul></ul>
- 23. Accommodating an Adverse Shift in Aggregate Supply Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply Aggregate demand, AD Copyright © 2004 South-Western Short-run aggregate supply, AS P 2 A P AS 2 3. . . . which causes the price level to rise further . . . 4. . . . but keeps output at its natural rate. 2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . 1. When short-run aggregate supply falls . . . AD 2 C P 3
- 24. Equilibrium in the Money Market Quantity of Money Interest Rate 0 Quantity fixed by the Fed Money demand Money supply r 2 M 2 d M d r 1 Equilibrium interest rate
- 25. Price and Quantity Demanded <ul><li>The price level is one determinant of the quantity of money demanded. </li></ul><ul><li>A higher price level increases the quantity of money demanded for any given interest rate. </li></ul><ul><li>Higher money demand leads to a higher interest rate. </li></ul><ul><li>The quantity of goods and services demanded falls. </li></ul><ul><li>The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded. </li></ul>
- 26. The Money Market and the Slope of the Aggregate-Demand Curve Quantity of Money Quantity fixed by the Fed 0 Interest Rate Money supply (a) The Money Market (b) The Aggregate-Demand Curve Quantity of Output 0 Price Level Aggregate demand Money demand at price level P 2 , MD 2 Money demand at price level P , MD 3. . . . which increases the equilibrium interest rate . . . 2. . . . increases the demand for money . . . P 2 Y 2 Y P 4. . . . which in turn reduces the quantity of goods and services demanded. 1. An increase in the price level . . . r r 2
- 27. Fed’s Monetary Injection <ul><li>The Fed can shift the aggregate demand curve when it changes monetary policy. </li></ul><ul><li>An increase in the money supply shifts the money supply curve to the right. </li></ul><ul><li>Without a change in the money demand curve, the interest rate falls. </li></ul><ul><li>Falling interest rates increase the quantity of goods and services demanded. </li></ul>
- 28. A Monetary Injection Aggregate demand, A D Y Quantity of Money 0 Interest Rate (a) The Money Market (b) The Aggregate-Demand Curve Quantity of Output 0 Price Level MS 2 Money supply, MS Y P Money demand at price level P AD 2 r r 2 3. . . . which increases the quantity of goods and services demanded at a given price level. 2. . . . the equilibrium interest rate falls . . . 1. When the Fed increases the money supply . . .
- 29. Impacts of Monetary Policy on Aggregate Demand <ul><li>When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the right. </li></ul><ul><li>When the Fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the left. </li></ul>
- 30. Forms of Monetary Policy <ul><li>Monetary policy can be described either in terms of the money supply or in terms of the interest rate. </li></ul><ul><li>Changes in monetary policy can be viewed either in terms of a changing target for the interest rate or in terms of a change in the money supply . </li></ul><ul><li>A target for the federal funds rate affects the money market equilibrium, which influences aggregate demand. </li></ul>
- 31. Fiscal Policy <ul><li>Fiscal policy refers to the government ’ s choices regarding the overall level of government purchases or taxes. </li></ul><ul><li>Fiscal policy influences saving, investment, and growth in the long run. </li></ul><ul><li>In the short run, fiscal policy primarily affects the aggregate demand. </li></ul>
- 32. Fiscal Policy: continued <ul><li>When policymakers change the money supply or taxes, the effect on aggregate demand is indirect — through the spending decisions of firms or households. </li></ul><ul><li>When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly. </li></ul>
- 33. Two Macroeconomic Effects <ul><li>There are two macroeconomic effects from the change in government purchases: </li></ul><ul><ul><li>The multiplier effect </li></ul></ul><ul><ul><li>The crowding-out effect </li></ul></ul>
- 34. The Multiplier Effect Quantity of Output Price Level 0 Aggregate demand, AD 1 $20 billion AD 2 AD 3 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion . . . 2. . . . but the multiplier effect can amplify the shift in aggregate demand.
- 35. The Crowding-Out Effect Quantity of Money Quantity fixed by the Fed 0 Interest Rate Money demand, MD Money supply (a) The Money Market Quantity of Output 0 Price Level Aggregate demand, AD 1 (b) The Shift in Aggregate Demand r 3. . . . which increases the equilibrium interest rate . . . 2. . . . the increase in spending increases money demand . . . M D 2 4. . . . which in turn partly offsets the initial increase in aggregate demand. AD 2 AD 3 1. When an increase in government purchases increases aggregate demand . . . r 2 $20 billion

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