This document summarizes a lecture on monetary and fiscal policy. It discusses the theory of liquidity preference, how central banks use monetary policy to influence interest rates and aggregate demand through money supply adjustments. It also explains fiscal policy tools like government spending and taxation, and the multiplier and crowding-out effects. The lecture concludes with a case study on Vietnam's 2019 stabilization policy in response to 7% GDP growth and 5.25% inflation.

1. MACROECONOMICS
LECTURE 8

2. MONETARY
AND
FISCAL POLICY
Chapter 34

3. Lecture Objectives
1. Theory of liquidity preference
2. Monetary policy
3. Fiscal policy
• Multiplier effect
• Crowding-out effect
4. Synergy of the monetary and fiscal
policy
5. Case study

4. Aggregate Demand
Quantity of
Output
Price
Level
0
Aggregate
demand
P1
Y1 Y2
P2
M
Value

5. Aggregate
demand
(b) Commodity & service Market
Quantity
of Output
0
Price
Level
(a) The Money Market
Quantity
of Money
Quantity fixed
by the CB
0
r1
Money
supply
Interest
Rate
Money demand at
price level P1, MD1
Y1
P1
The Money Market and Aggregate Demand
Money demand at
price level P2, MD2
2. …increases
the demand for
money…
1. An increase in the
price level…
P2
3. …which increases the
equilibrium rate…
r2
4. …which in turn reduces the
quantity of goods and services
demanded.
Y2

6. The Theory of Liquidity Preference
◦ The interest rate adjusts to balance the
supply and demand for money.

7. Equilibrium in the Money Market
Quantity of
Money
Interest
Rate
0
Money
demand
Quantity fixed
by the CB
Money
supply
r2
M d
2
r1
M d
1
Equilibrium
interest rate

8. 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
Monetary Policy

9. Y2
AD2
3. …which
increases the
quantity of goods
and services
demanded at a
given price level.
1. When
the CB
increases
the money
supply…
MS2
Regulated Money Supply
Y1
P
Quantity
of Output
0
Price
Level
Aggregate
demand, AD1
(a) The Money Market
Quantity
of Money
0
Money
supply,
MS1
r1
Interest
Rate
(b) The Aggregate-Demand Curve
r2
2. …the equilibrium
interest rate falls…

10. 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.

11. Strengths of Monetary Policy
◦Powerful to pursue contractionary policies
◦Swift and flexible action
◦Political acceptability

12. ◦Difficult to predict time-lag between action and
outcome
◦Weak when trying to stimulate economic activity.
Weaknesses of Monetary Policy

13. The Fiscal Policy
Revenue Outlays
BUDGET
$
$
Income tax
Business tax
Sales Tax
Excise duty
Non-tax rev.
Other
Soc. Security
Health
Education
Defence
Public serv’s
Public debt
interest
Other

14. Fiscal policy - Measures
◦Government spendings, led to effects:
◦The multiplier effect
◦The crowding-out effect
◦Taxation

15. Multiplier Effect
Aggregate demand, AD1
Quantity
of Output
0
Price
Level
AD2
1. An increase in government
purchases of $20 billion
initially increases aggregate
demand by $20 billion…
$20 billion
AD3
2. …but the multiplier effect can amplify
the shift in aggregate demand.

16. 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.

17. The Crowding-Out Effect
◦Crowding-out effect: reduction in
demand that results when a fiscal
expansion raises the interest rate

18. AD3
4. …which in turn
partly offsets the
initial increase in
aggregate
demand.
The Crowding-Out Effect
Aggregate demand, AD1
(b) The Shift in Aggregate Demand
Quantity of Output
0
Price
Level
(a) The Money Market
Quantity
of Money
Quantity fixed
by the Fed
0
r1
Money demand, MD1
Money
supply
Interest
Rate
1. When an increase in government
purchases increases aggregate demand…
AD2
$20 billion
3. …which increases the equilibrium
interest rate…
r2
MD2
2. …the increase
in spending
increases money
demand…

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

20. ◦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
Strengths of Fiscal Policy

21. ◦Uncertainty of its outcomes
◦Timing/ Implementation lags
◦Political sensitivity
◦“Crowding-out” effect of budget deficit
Weaknesses of Fiscal Policy

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

23. 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?

24. Hints: combined monetary and fiscal policy:
• Discout rate?
• Minimal capital requirement at banks?
• State invested infrastructure projects?
• Salary scheme at public sector?

25. Lecture Review
◦Theory of liquidity preference
◦Monetary policy
◦Fiscal policy
◦Synergy of monetary and fiscal policy
◦Case study