曼昆经济学原理第五版答案英文ch32

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32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND WHAT’S NEW:

The section on “The Economy in the Long Run and the Short Run” has been shortened and is now an FYI box. The formula for the multiplier is now in the text, and a new section has been added on “Other Applications of the Multiplier Effect.” There is a new Case Study on “Why the Fed Watches the Stock Market (and Vice Versa).” There are also two new in the News boxes: “European Central Bankers Expand Aggregate Demand” and “Japan Tries a Fiscal Stimulus.”

LEARNING OBJECTIVES: By the end of this chapter, students should understand:

 the theory of liquidity preference as a short-run theory of the interest rate.

 how monetary policy affects interest rates and aggregate demand.

 how fiscal policy affects interest rates and aggregate demand.

 the debate over whether policymakers should try to stabilize the economy.

KEY POINTS: 1. In developing a theory of short-run economic fluctuations, Keynes proposed the theory of

liquidity preference to explain the determinants of the interest rate. According to this theory, the interest rate adjusts to balance the supply and demand for money.

2. An increase in the price level raises money demand and increases the interest rate that

brings the money market into equilibrium. Because the interest rate represents the cost of borrowing, a higher interest rate reduces investment and, thereby, the quantity of goods and services demanded. The downward-sloping aggregate-demand curve expresses this negative relationship between the price level and aggregate quantity demanded.

3. Policymakers can influence aggregate demand with monetary policy. An increase in the

money supply reduces the equilibrium interest rate for any given price level. Because a

lower interest rate stimulates investment spending, the aggregate-demand curve shifts to the right. Conversely, a decrease in the money supply raises the equilibrium interest rate for any given price level and shifts the aggregate demand curve to the left.

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2 Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY

4. Policymakers can also influence aggregate demand with fiscal policy. An increase in

government purchases or a cut in taxes shifts the aggregate-demand curve to the right. A decrease in government purchases or an increase in taxes shifts the aggregate-demand curve to the left.

5. When the government alters spending or taxes, the resulting shift in aggregate demand can

be larger or smaller than the fiscal change. The multiplier effect tends to amplify the effects of fiscal policy on aggregate demand. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

6. Because monetary and fiscal policy can influence aggregate demand, the government

sometimes uses these policy instruments in an attempt to stabilize the economy. Economists disagree about how active the government should be in this effort. According to the

advocates of active stabilization policy, changes in attitudes by households and firms shift aggregate demand; if the government does not respond, the result is undesirable and unnecessary fluctuations in output and employment. According to critics of active

stabilization policy, monetary and fiscal policy work with such long lags that attempts at stabilizing the economy often end up being destabilizing.

CHAPTER OUTLINE:

I. How Monetary Policy Influences Aggregate Demand

Students are very interested in the way in which the Fed changes interest rates. Review what they learned about the Fed and its tools to change the money supply covered in Chapter 15. The effects of monetary policy are easy to show graphically. Begin with money supply, money demand, and an equilibrium interest rate. Show how both an increase and a decrease in the money supply affect interest rates. A.

The aggregate demand curve is downward sloping for three reasons. 1.

The wealth effect The interest-rate effect The exchange-rate effect

All three effects occur simultaneously, but are not of equal importance.

Because a household’s money holdings are a small part of total wealth, the wealth effect is relatively small.

Because imports and exports are a small fraction of U.S. GDP, the exchange-rate effect is also fairly small for the United States. Thus, the most important reason for the downward-sloping aggregate demand curve is the interest rate effect.

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Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY C.

Definition of Theory of Liquidity Preference: Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance.

The Theory of Liquidity Preference 1.

This theory is an explanation of the supply and demand for money and how they relate to the interest rate. Money Supply

Figure 32-1 a.

The Fed can alter the supply of money using open market

operations, changes in the discount rate, and changes in reserve requirements.

Because the Fed can control the size of the money supply

directly, the quantity of money supplied does not depend on any other variables, including the interest rate. Thus, the supply of money is a vertical line.

The money supply in the economy is controlled by the Federal Reserve.

Money Demand a. Any asset’s liquidity refers to the ease with which that asset can

be converted into a medium of exchange. Thus, money is the most liquid asset in the economy. b.

The liquidity of money explains why people choose to hold it instead of other assets that could earn them a higher return. However, the return on other assets (the interest rate) is the opportunity cost of holding money. All else equal, as the interest rate rises, the quantity of money demanded will fall. Therefore, the demand for money will be downward sloping.

If the interest rate was higher than the equilibrium interest rate, the quantity of money that people want to hold is less than the quantity that the Fed has supplied. Thus, people will try to buy bonds or deposit funds in an interest bearing account. This increases the funds available for lending, pushing interest rates down.

The interest rate adjusts to bring money demand and money supply into balance.

Equilibrium in the Money Market

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Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY

Interest Rate Money supply r* Money demand Quantity of money c.

If the interest rate was lower than the equilibrium interest rate, the quantity of money that people want to hold is greater than the quantity that the Fed has supplied. Thus, people will try to sell bonds or withdraw funds from an interest bearing account. This decreases the funds available for lending, pulling interest rates up.

FYI: Interest Rates in the Long Run and the Short Run

It may appear we have two theories of how interest rates are determined. a. b.

In Chapter 25, we said that the interest rate adjusts to balance the supply and demand for loanable funds.

In this chapter, we proposed that the interest rate adjusts to balance the supply and demand for money.

a. b.

The price level adjusts to balance the supply and demand for money. Changes in the supply of money lead to proportionate changes in the price level.

Output is determined by the levels of resources and technology available.

For any given level of output, the interest rate adjusts to balance the supply and demand for loanable funds.

In the long run, the economy’s level of output, the interest rate, and the price level are determined by in the following manner:

To understand how these two statements can both be true, we must discuss the difference between the short run and the long run.

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Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY

In the short run, the economy’s level of output, the interest rate, and the price level are determined by in the following manner: a.

The price level is stuck at some level and is unresponsive to changes in economic conditions.

For any given price level, the interest rate adjusts to balance the supply and demand for money.

The level of output responds to changes in the aggregate

demand for goods and services, which is in part determined by the interest rate.

The Downward Slope of the Aggregate-Demand Curve

Figure 32-2 1.

When the price level increases, the quantity of money that people need to hold becomes larger. Thus, an increase in the price level leads to an increase in the demand for money, shifting the money demand curve to the right.

For a fixed money supply, the interest rate must rise to balance the supply and demand for money. MS P

r 3.

MD2 AD MD1 Q of Money Output At a higher interest rate, the cost of borrowing increases and the return on saving increases. Thus, consumers will choose to spend less and will be less likely to invest in new housing. Firms will be less likely to borrow funds for new equipment or structures. In short, the quantity of goods and services purchased in the economy will fall.

This implies that as the price level increases, the quantity of goods and services demanded falls. This is Keynes’s interest-rate effect.

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6 Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY G. Changes in the Money Supply

Figure 32-3 1.

MS1 MS2 P r AD2 MD Q of Money AD1 Output Example: The Fed buys government bonds in open-market operations.

ALTERNATIVE CLASSROOM EXAMPLE:

Suppose the Fed sells government bonds in the open market. The following would occur:

1. The supply of money will decrease, shifting the money supply curve to the left.

2. The equilibrium interest rate will rise, raising the cost of borrowing and the return on saving.

3. Households will lower consumption and firms will lower investment.

4. The quantity of goods and services demanded will fall at every price level, shifting the

aggregate-demand curve to the left. 2. This will increase the supply of money, shifting the money supply curve

to the right. The equilibrium interest rate will fall.

The lower interest rate reduces the cost of borrowing and the return to saving. This encourages households to increase their consumption and desire to invest in new housing. Firms will also increase investment, building new factories and purchasing new equipment.

The quantity of goods and services demanded will rise at every price level, shifting the aggregate-demand curve to the right.

Thus, a monetary injection by the Fed increases the money supply, leading to a lower interest rate, and a larger quantity of goods and services demanded.

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Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY 7

Point out the circumstances under which the Fed is likely to increase the money supply. Then, discuss the circumstances under which the Fed is likely to decrease the money supply. Discuss the short-run and long-run effects of each. H.

The Role of Interest-Rate Targets in Fed Policy

Show students that the Fed can target either the money supply or the interest rate, but not both. 1.

Because changes in the money supply lead to changes in interest rates, monetary policy can be described either in terms of the money supply or in terms of the interest rate.

The Fed has chosen to use this interest rate as a target in part because the money supply is difficult to measure exactly. The target is reevaluated every six weeks when the Federal Open Market Committee meets.

In recent years, the Fed has conducted policy by setting a target for the federal funds rate (the interest rate that banks charge one another for short-term loans).

Make sure that you point out to students that, while the media describes the actions of the Federal Reserve as “changing interest rates,” they instead could be described as “changing the money supply.” I.

Case Study: Why the Fed Watches the Stock Market (and Vice Versa)

When the stock market booms, households become wealthier, and this increased wealth stimulates consumer spending. Increases in stock prices make it attractive for firms to issue new shares of stock and this increases investment spending.

A booming stock market expands the aggregate demand for goods and services.

Since one of the Fed’s goals is to stabilize aggregate demand, the Fed may respond to a booming stock market by keeping the supply of money demand and raising interest rates. The opposite would hold true if the stock market would fall.

Stock market participants also keep an eye on the Fed’s policy plans. When the Fed lowers the money supply, it makes stocks less attractive because alternative assets (such as bonds) pay higher interest rates. Also, higher interest rates may lower the expected profitability of firms.

In the News: European Central Bankers Expand Aggregate Demand Harcourt, Inc. items and derived items copyright  2001 by Harcourt, Inc.

Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY

In December of 1998, eleven European central banks cut interest rates to stimulate growth.

II. 2. This is an article from The New York Times discussing this situation.

How Fiscal Policy Influences Aggregate Demand

Point out that compared with any other economic participant, the federal government’s budget is the largest in the world. A.

When the government changes the level of its purchases, it influences aggregate demand directly. An increase in government purchases shifts the aggregate-demand curve to the right, while a decrease in

government purchases shifts the aggregate-demand curve to the left. There are two macroeconomic effects that cause the size of the shift in the aggregate-demand curve to be different from the change in the level of government purchases. They are called the multiplier effect and the crowding-out effect.

Changes in Government Purchases

Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes.

The Multiplier Effect

Figure 32-4 1.

When the government buys a product from a company, the immediate impact of the purchase is to raise profits and employment at that firm. As a result, owners and workers at this firm will see an increase in

income, and will therefore likely increase their own consumption. Thus, total spending rises by more than the increase in government purchases.

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Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY

Definition of Multiplier Effect: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

The multiplier effect goes on and on. When consumers spend part of their additional income, it provides additional income for other

consumers. These consumers then spend some of this additional income, raising the incomes of yet another group of consumers. A Formula for the Spending Multiplier a.

Change in government purchases = $20 billion First change in consumption = MPC × $20 billion Second change in consumption = MPC2 × $20 billion Third change in consumption = MPC3 × $20 billion

      Total Change = (1 + MPC + MPC2 + MPC3 + . . .) × $20 billion

multiplier = 1/(1-MPC)

Note that the size of the multiplier depends on the size of the marginal propensity to consume.

Because this expression is an infinite geometric series, it also can be written as:

This means that the multiplier can be written as: Multiplier = (1 + MPC + MPC2 + MPC3 + . . .).

To find the total impact on the demand for goods and services, we add up all of these effects:

Incomes will increase by $20 billion, so consumption will rise by MPC × $20 billion. The second increase in consumption will be equal to MPC × (MPC × $20 billion) or MPC2 × $20 billion. Example: The government spends $20 billion on new planes. Assume that MPC = 3/4.

The marginal propensity to consume (MPC) is the fraction of extra income that a household consumes rather than saves.

Other Applications of the Multiplier Effect a.

The multiplier effect applies to any event that alters spending on any component of GDP (consumption, investment, government purchases, or net exports).

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10 Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY

Examples include a reduction in net exports due to a recession in another country or a stock market boom that raises consumption.

The Crowding-Out Effect

Figure 32-5 1.

The crowding-out effect works in the opposite direction.

Definition of Crowding-Out Effect: the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. As we discussed earlier, when the government buys a product from a company, the immediate impact of the purchase is to raise profits and employment at that firm. As a result, owners and workers at this firm will see an increase in income, and will therefore likely increase their own consumption.

If consumers want to purchase more goods and services, they will need to increase their holdings of money. This shifts the demand for money to the right, pushing up the interest rate.

2. 3.

Price Level AD2 AD3 AD1 Output 5.

The higher interest rate raises the cost of borrowing and the return to saving. This discourages households from spending their incomes for new consumption or investing in new housing. Firms will also decrease investment, choosing not to build new factories or purchase new equipment.

Thus, even though the increase in government purchases shifts the aggregate demand curve to the right, this fall in consumption and investment will pull aggregate demand back toward the left. Thus, aggregate demand increases by less than the increase in government purchases.

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Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY

Therefore, when the government increases its purchases by $X, the aggregate demand for goods and services could rise by more or less than $X, depending on whether the multiplier effect or the crowding-out effect is larger. a.

If the multiplier effect is greater than the crowding-out effect, aggregate demand will rise by more than $X.

If the multiplier effect is less than the crowding-out effect, aggregate demand will rise by less than $X.

In the News: Japan Tries a Fiscal Stimulus

1. 2.

In the 1990s, Japan experienced a long and deep recession.

This is an article from The New York Times describing the fiscal policy used by the Japanese government.

Changes in taxes affect a household’s take-home pay. If the

government reduces taxes, households will likely spend some of this extra income, shifting the aggregate-demand curve to the right. If the government raises taxes, household spending will fall, shifting the aggregate-demand curve to the left.

The size of the shift in the aggregate-demand curve will also depend on the sizes of the multiplier and crowding-out effects. a.

Another important determinant of the size of the shift in aggregate

demand due to a change in taxes is whether people believe that the tax change is permanent or temporary. A permanent tax change will have a larger effect on aggregate demand than a temporary one.

Higher incomes lead to greater spending, which means a higher demand for money. Interest rates rise and investment spending falls. This is the crowding-out effect.

When the government lowers taxes and consumption increases, earnings and profits rise, which further stimulate consumer spending. This is the multiplier effect.

Changes in Taxes

FYI: How Fiscal Policy Might Affect Supply

Because people respond to incentives, a decrease in tax rates may cause individuals to work more, because they get to keep more of what they earn. If this occurs, the aggregate-supply curve would increase (shift to the right).

Changes in government purchases may also affect supply. If the government increases spending on capital projects or education, the productive ability of the economy is enhanced, shifting aggregate supply to the right.

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12 III. Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY Using Policy to Stabilize the Economy

If you would like, now would be a good time to cover the debate concerning whether “Monetary and Fiscal Policymakers Should Try to Stabilize the Economy” from Chapter 34. A.

The Case for Active Stabilization Policy 1.

Example: The government reduces its spending to cut the budget deficit, lowering aggregate demand (shifting the curve to the left). a.

The Fed can offset this government action by increasing the money supply.

This would lower interest rates and boost spending, shifting the aggregate-demand curve back to the right.

The Employment Act occurred in response to a book by John Maynard Keynes, an economist who emphasized the important role of aggregate demand in explaining short-run fluctuations in the economy. Keynes also felt strongly that the government should stimulate

aggregate demand whenever necessary to keep the economy at full employment. a.

Keynes felt that aggregate demand responds strongly to pessimism and optimism. When consumers are pessimistic, aggregate demand is low, output is low, and unemployment is increased. When consumers are optimistic, aggregate demand is high, output is high, and unemployment is lowered.

It is possible for the government to adjust monetary and fiscal policy in response to optimistic or pessimistic views. This helps stabilize aggregate demand, keeping output stable at full employment.

The second implication of the Employment Act is that the

government should respond to changes in the private economy in order to stabilize aggregate demand.

One implication of the Employment Act is that the government should avoid being a cause of economic fluctuations.

Policy instruments are often used in this manner to stabilize demand. Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946.

Case Study: Keynesians in the White House

In 1961, President Kennedy pushed for a tax cut to stimulate aggregate demand. Several of his economic advisors were followers of Keynes.

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Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY

In 1993, President Clinton proposed a stimulus package to help the economy recover from a recession.

Some economists believe that fiscal and monetary policy tools should only be used to help the economy achieve long-run goals, such as low inflation and economic growth.

The primary argument against active policy is that these policy tools may affect the economy with a large time lag. a.

With monetary policy, the change in money supply leads to a change in interest rates. This change in interest rates affects investment spending. However, investment decisions are usually made well in advance, so the effects from changes in investment will not likely be felt in the economy very quickly.

The lag in fiscal policy is generally due to the political process. Changes in spending and taxes must be approved by both the House and the Senate (after going through committees in both houses).

The Case Against Active Stabilization Policy

Automatic Stabilizers 1.

Definition of Automatic Stabilizers: changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

The most important automatic stabilizer is the tax system. a.

The personal income tax depends on the level of households’ incomes and the corporate income tax depends on the level of firm profits.

This implies that the government’s tax revenue falls during a recession. This tax cut stimulates aggregate demand and reduces the magnitude of this economic downturn.

When the economy falls into a recession, incomes and profits fall.

By the time these policies take effect, the condition of the economy may have changed. This could lead to even larger problems.

These transfer payments provides additional income to recipients, stimulating spending.

More individuals become eligible for transfer payments during a recession.

Government spending is also an automatic stabilizer.

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14 Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY

Thus, just like the tax system, our system of transfer payments helps to reduce the size of short-run economic fluctuations.

In the News: The Independence of the Federal Reserve

The Federal Reserve operates with little political pressure due to the way that it was originally set up. Some individuals in Congress have proposed that the Fed’s independence be reduced.

This is an article from The Boston Globe by two economists arguing that the Fed’s independence is important for the long run stability of our economy.

ADJUNCT TEACHING TIPS AND WARM-UP ACTIVITIES:

1. Check to see how much your students remember about the Fed from Chapter 15. Divide the

class in half and give them a “pretend” pop quiz. Don’t let them use their book or notes. Ask half of the class to list the three ways that the Fed can increase the money supply and ask the other half to list three ways that the Fed can decrease the money supply. After a few minutes, have students report what they remembered.

SOLUTIONS TO TEXT PROBLEMS:

Quick Quizzes 1. A decrease in the money supply affects the equilibrium interest rate because in order for

money supply to equal money demand, money demand must decline. The interest rate must therefore rise to induce a decline in money demand, restoring equilibrium. The decrease in the money supply reduces aggregate demand because the higher interest rate causes households to buy fewer houses, reducing the demand for residential investment, and causes firms to spend less on new factories and new equipment, reducing business investment.

2. If the government reduces spending on highway construction by $10 billion, the

aggregate-demand curve shifts to the left because government purchases are lower. The shift to the left of the aggregate-demand curve could be more than $10 billion because of the multiplier effect or it could be less than $10 billion because of the crowding-out effect.

3. If people become pessimistic about the future, they’ll spend less, causing the aggregate-demand curve to shift to the left. If the Fed wants to stabilize aggregate demand, it

should increase the money supply. The increase in the money supply will cause the interest rate to decline, thus stimulating residential and business investment. The Fed might choose not to do this because by the time the policy action takes effect, the long lag time might mean the economy would have recovered on its own, and the increase in the money supply will cause inflation.

Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY 15

Questions for Review 1. The theory of liquidity preference is Keynes's theory of how the interest rate is

determined. According to the theory, the aggregate-demand curve slopes downward because: (1) a higher price level raises money demand; (2) higher money demand leads to a higher interest rate; and (3) a higher interest rate reduces the quantity of goods and services demanded. Thus the price level has a negative relationship with the quantity of goods and services demanded.

2. A decrease in the money supply shifts the money-supply curve to the left. The money-supply curve now intersects the money-demand curve at a higher interest rate. The

higher interest rate reduces the demand for consumption and investment, so aggregate demand falls. Thus, for a given price level, the quantity of goods and services demanded declines, so the aggregate-demand curve shifts to the left.

3. If the government buys $3 billion of police cars, aggregate demand might increase by

more than $3 billion because of the multiplier effect on aggregate demand. Aggregate demand might increase by less than $3 billion because of the crowding-out effect on aggregate demand.

4. If pessimism sweeps the country, households reduce consumption spending and firms

reduce investment, so aggregate demand falls. If the Fed wants to stabilize aggregate demand, it must increase the money supply, reducing the interest rate, which will induce households to save less and spend more and will encourage firms to invest more, both of which will increase aggregate demand. If the Fed doesn't increase the money supply, Congress could increase government purchases or reduce taxes to increase aggregate demand.

5. Government policies that act as automatic stabilizers include the tax system and

government spending through the unemployment-benefit system. The tax system acts as an automatic stabilizer because when incomes are high, people pay more in taxes, so they can't spend as much. When incomes are low, so are taxes; thus people can spend more. The result is that spending is partly stabilized. Government spending through the unemployment-benefit system acts as an automatic stabilizer because in recessions the government transfers money to the unemployed so their incomes don't fall as much and thus their spending won't fall as much.

Problems and Applications 1. a. When the Fed’s bond traders buy bonds in open-market operations, the money-supply curve shifts to the right from MS1 to MS2, as shown in Figure 32-1. The

result is a decline in the interest rate.

16 Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY

Figure 32-1

When an increase in credit card availability reduces the cash people hold, the

money-demand curve shifts to the left from MD1 to MD2, as shown in Figure 32-2. The result is a decline in the interest rate.

Figure 32-2

When the Federal Reserve reduces reserve requirements, the money supply increases, so the money-supply curve shifts to the right from MS1 to MS2, as shown in Figure 32-1. The result is a decline in the interest rate.

When households decide to hold more money to use for holiday shopping, the money-demand curve shifts to the right from MD1 to MD2, as shown in Figure 32-3. The result is a rise in the interest rate.

Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY 17

Figure 32-3

When a wave of optimism boosts business investment and expands aggregate demand, money demand increases from MD1 to MD2 in Figure 32-3. The increase in money demand increases the interest rate.

When an increase in oil prices shifts the short-run aggregate-supply curve

upward, the increased price level increases money demand. The money-demand curve shifts to the right from MDa rise in the interest rate.

1 to MD2, as shown in Figure 32-3. The result is

Figure 32-4

When more ATMs are available, so that people's money demand is reduced, the money-demand curve shifts to the left from MDIf the Fed does not change the money supply, which is at MS1 to MD2, as shown in Figure 32-4. will decline from r1, the interest rate 1 to r2. The decline in the interest rate shifts the aggregate

18 Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY

demand curve to the right, as consumption and investment increase.

If the Fed wants to stabilize aggregate demand, it should reduce the money

supply to MS2, so the interest rate will remain at r1 and aggregate demand won't change.

A tax cut that is permanent will have a bigger impact on consumer spending and aggregate demand. If the tax cut is permanent, consumers will view it as adding substantially to their financial resources, and they will increase their spending

substantially. If the tax cut is temporary, consumers will view it as adding just a little to their financial resources, so they won't increase spending as much.

The decline in the U.S. interest rate in 1991 doesn't necessarily imply that monetary policy was expansionary. Since the United States was in a recession, money demand declined. The decline in money demand could have accounted for the decline in the interest rate, as shown in Figure 32-5.

a. b.

Figure 32-5

Legislation allowing banks to pay interest on checking deposits increases the

return to money relative to other financial assets, thus increasing money demand. If the money supply remained constant (at MS1), the increase in the demand for money would have raised the interest rate, as shown in Figure 32-6. The rise in the interest rate would have reduced consumption and investment, thus reducing aggregate demand and output.

To maintain a constant interest rate, the Fed would need to increase the money supply from MS1 to MS2. Then aggregate demand and output would be unaffected.

Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY 19

Figure 32-6

6. 7.

The demand for net exports is stimulated by expansionary monetary policy through the Mundell-Fleming exchange-rate effect, discussed in Chapter 31. The decline in the interest rate increases net foreign investment, thus increasing net exports. a.

If there's no crowding out, then the multiplier equals 1/(1-MPC). Since the multiplier is 3, then MPC = 2/3.

If there's crowding out, then the MPC would be larger than 2/3. An MPC that's larger than 2/3 would lead to a larger multiplier than 3, which is then reduced down to 3 by the crowding-out effect.

The initial effect of the tax reduction of $20 billion is to increase aggregate

demand by $20 billion x 3/4 (the MPC) = $15 billion. The cut in taxes increases consumption spending depending on the MPC.

Additional effects follow this initial effect as the added incomes get spent. The second round leads to increased consumption spending of $15 billion x 3/4 = $11.25 billion. The third round gives an increase in consumption of $11.25 billion x 3/4 = $8.44 billion. The effects continue indefinitely. Adding them all up gives a total effect that depends on the multiplier. With an MPC of 3/4, the multiplier is 1/(1-3/4) = 4. So the total effect is $15 billion x 4 = $60 billion. Government purchases have an initial effect of the full $20 billion, since they increase aggregate demand directly by that amount. The total effect of an increase in government purchases is thus $20 billion x 4 = $80 billion. So government purchases lead to a bigger effect on output than a tax cut does. The difference arises because government purchases affect aggregate demand by the full amount, but a tax cut is partly saved by consumers, so doesn’t lead to as much of an increase in aggregate demand.

If government spending increases, aggregate demand rises, so money demand rises. The increase in money demand leads to a rise in the interest rate and thus a decline in aggregate demand if the Fed doesn't respond. But if the Fed maintains a fixed interest

20 Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY rate, it will increase money supply, so aggregate demand won't decline. Thus the effect on aggregate demand from an increase in government spending will be larger if the Fed maintains a fixed interest rate.

10.

11.

12. a.

Expansionary fiscal policy is more likely to lead to a short-run increase in

investment if the investment accelerator is large. A large investment accelerator means that the increase in output caused by expansionary fiscal policy will induce a large increase in investment. Without a large accelerator, investment might decline because the increase in aggregate demand will raise the interest rate.

Expansionary fiscal policy is more likely to lead to a short-run increase in

investment if the interest sensitivity of investment is small. Since fiscal policy increases aggregate demand, thus increasing money demand and the interest rate, the greater the sensitivity of investment to the interest rate the greater the decline in investment will be, which will offset the positive accelerator effect. An increase in government spending would shift the aggregate demand curve to the right, increasing output. The rise in output would raise consumption spending, since people would have higher incomes, and raise investment spending through the accelerator. But money demand would also increase, raising the interest rate. This would tend to reduce consumption, as people would save more, and reduce investment, since the cost of investing would be higher. Overall, the changes in both consumption and investment are ambiguous.

A reduction in taxes would directly increase consumption spending, since people would have higher after-tax incomes. Also, since the reduction in taxes

increases consumption spending, aggregate demand increases, so total output increases. The rise in output would raise consumption spending further, since people would have higher incomes, and raise investment spending through the accelerator. But money demand would also increase, raising the interest rate. This would tend to reduce consumption, as people would save more, and reduce investment, since the cost of investing would be higher. Overall, consumption must increase (otherwise aggregate demand wouldn't have increased at all) while the change in investment is ambiguous.

An expansion in the money supply reduces the interest rate, thus increasing aggregate demand and output. The rise in output would raise consumption spending, since people would have higher incomes, and raise investment spending through the accelerator. The lower interest rate would increase

consumption, as people would save less, and increase investment, since the cost of investing would be lower. Overall, both consumption and investment would increase.

Tax revenue declines when the economy goes into a recession because taxes are closely related to economic activity. In a recession, people's incomes and wages fall, as do firms' profits, so taxes on all these things decline.

Government spending rises when the economy goes into a recession because more people get unemployment-insurance benefits, welfare benefits, and other forms of income support.

Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY c.

If the government were to operate under a strict balanced-budget rule, it would have to raise tax rates or cut government spending in a recession. Both would reduce aggregate demand, making the recession more severe.

If there were a contraction in aggregate demand, the Fed would need to

increase the money supply to increase aggregate demand and stabilize the price level, as shown in Figure 32-7. By increasing the money supply, the Fed is able to shift the aggregate-demand curve back to AD1 from AD2. This policy stabilizes output as well as the price level.

13.

Figure 32-7

Figure 32-8

22 b.

Chapter 32 — THE INFLUENCE OF MONETARY AND FISCAL POLICY

If there were an adverse shift in short-run aggregate supply, the Fed would need to decrease the money supply to stabilize the price level, shifting the aggregate-demand curve to the left from AD1 to AD2, as shown in Figure 32-8. This worsens the recession caused by the shift in aggregate supply. To stabilize output instead of the price level, the Fed would need to increase the money supply, shifting the aggregate-demand curve from AD1 to AD3, but this action would raise the price level.

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