Macroeconomic problems and policies
Professional Development Course in Knowledge Enrichment for
Senior Secondary Economics Teachers
Outline of Lecture 4 - Macroeconomics: Macroeconomic problems and policies
I. How fiscal policy influences aggregate demand (Output and price level)
Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes.
Ø Marginal Propensity to Consume (MPC), Marginal Propensity to Save (MPS)
Ø Fiscal policy
l Definition of budget surplus: an excess of tax revenue over government spending (T>G).
l Definition of budget deficit: a shortfall of tax revenue from government spending (G>T).
l Definition of balanced budget: tax revenue equals government spending (G=T).
Ø Changes in government purchases
l An increase in government purchases à shifts the aggregate-demand curve to the right
l A decrease in government purchases à shifts the aggregate-demand curve to the left
Ø The multiplier effect
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
Ø A formula for the spending multiplier
Ø The Balanced Budget Multiplier
The balanced budget multiplier is the magnification effect on aggregate demand of a simultaneous change in government expenditure and taxes that leaves the budget balance unchanged.
Ø The crowding out effect
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.
The Crowding-Out Effect
1. An increase in government purchases increases aggregate demand (AD1 à AD2),
2. the increase in spending increases money demand (MD1 à MD2),
3. the equilibrium interest rate increases (r1 à r2),
4. it partly offsets the initial increase in aggregate demand (AD2 à AD3)
Ø Changes in taxes
l If the government reduces taxes
à households will spend more,
à the aggregate-demand curve shifts to the right.
l If the government raises taxes
à household will spend less,
à the aggregate-demand curve shifts to the left.
l The size of the shift in the aggregate-demand curve depends on the sizes of the multiplier and crowding-out effects.
l A permanent tax change will have a larger effect on aggregate demand than a temporary one.
II. How monetary policy influences aggregate demand (Output and price level)
Teaching advice
ü Students are very interested in the way in which the central bank changes interest rates. Review what they learned about the central bank and its tools to change the money supply.
ü 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.
Definition of theory of liquidity preference: Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance.
Teaching advice
ü Point out that when we discuss the "interest rate", we are discussing both the nominal interest rate and the real interest rate because we are assuming that they will move together.
Equilibrium in the Money Market
Equilibrium in the Money Market
The Downward Slope of the Aggregate-Demand Curve (Keynes’s interest-rate effect)
1. Price level (P1 à P2)à Quantity of money that people need to hold
2. Demand for money à Money demand curve shifts to the right (MD1 à MD2)
3. Interest rate to balance the supply and demand for money (r1 à r2)
à Cost of borrowing (Investment ) Return on saving (Consumption )
à Quantity of goods and services demanded in the economy
4. GDP (Y1 à Y2)
The Money Market and the Slope of the Aggregate-Demand Curve
III. Monetary policy
Ø Meaning of monetary policy
Monetary policy is changes in interest rates and the quantity of money in the economy.
Ø Concept of monetary base/ high powered money
l currency + bank reserve deposits
l controlled by the central bank
Factors affecting the monetary base
Factor / Effect onMonetary Base / Effect on
Money Supply
Open Market Purchase / /
Open Market Sale / /
Increase in discount window borrowing / /
Increase in the
discount rate / /
Ø Effect of monetary policy on the level of output and price
l Changes in the Money Supply
1. Supply of money à Money supply curve shifts to the right (MS1 à MS2)
2. Interest rate (r1 à r2)
à Cost of borrowing Return to saving
à Investment & Consumption
3. Quantity of goods and services demanded
à Aggregate-demand curve shifts to the right (AD1 à AD2)
A Monetary Injection
Ø Discussion about the role of interest rate targets in central bank policy
Ø Case Study: Why the central bank watches the stock market (and vice versa)
Stock market booms à households become wealthier à consumer spending
à It becomes attractive for firms to issue new shares of stock
à Investment spending
à Since one of the central bank’s goals is to stabilize AD
à The central bank may lower the supply of money raise the interest rates
à Stocks become less attractive because (i) alternative assets (such as bonds) pay higher interest rates, (ii) the expected profitability of firms is lowered
IV. Inflation and deflation (quantity theory of money)
Ø Definition of inflation and deflation
Inflation - Persistent increases in the general level of prices.
Deflation - Persistent decreases in the general level of prices.
Ø Relationship between nominal and real interest rates
Definition of nominal interest rate: the interest rate as usually reported without a correction for the effects of inflation.
Definition of real interest rate: the interest rate corrected for the effects of inflation.
Ø Redistributive effects – Unexpected inflation and deflation
l Arbitrary Redistributions of Wealth
Because inflation is often hard to predict, it imposes risk on both borrowers and lenders that the real value of the debt will differ from that expected when the loan is made.
Ø Inflation and Quantity Theory of Money
Definition of quantity theory of money: a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate.
l Definition of velocity of money (V): the rate at which money changes hands.
l To calculate velocity, we divide nominal GDP by the quantity of money.
l Definition of quantity equation: the equation M × V = P × Y, which relates the quantity of money (M), the velocity of money (V), and the dollar value of the economy’s output of goods and services (PY).
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