Bài giảng Macroeconomics - Chapter 4: Short-run economic fluctuation (Part 2) - Nguyễn Thùy Dung

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4.2 Monetary and Fiscal Policy
Monetary and Fiscal policy are used to offset shifts 
in AD which cause short-run fluctuations in output 
and employment.
▪ Monetary policy: the setting of the money supply 
by policymakers in the central bank
▪ Fiscal policy: changes in government spending or 
tax rates. demand by using monetary and fiscal 
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How Monetary Policy Influences AD
▪ Recall, the AD curve slopes downward for three 
reasons:
▪ The wealth effect
▪ The interest-rate effect
▪ The exchange-rate effect
▪ A supply-demand model that helps explain the 
interest-rate effect and how monetary policy 
affects AD.
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The Theory of 
Liquidity Preference
The theory of liquidity preference is developed 
in order to explain what factors determine the 
economy’s interest rate (denoted r)
According to the theory, the interest rate adjusts 
to balance the supply and demand for money.
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Money Supply
▪ The money supply is controlled by the Fed 
through:
❑Open-market operations
❑Changing the reserve requirements
❑Changing the discount rate
▪ Thus, the quantity of money supplied does 
not depend on the interest rate and is vertical.
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Money Demand
Money demand is determined by several factors.
According to the theory of liquidity preference, 
one of the most important factors is r
A household’s “money demand” reflects its 
preference for liquidity. 
• People choose to hold money because money 
can be used to buy other goods and services.
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The opportunity cost of holding money is the 
interest that could be earned on interest-earning 
assets.
An increase in the interest rate raises the 
opportunity cost of holding money.
➔ The quantity of money demanded is reduced
Money Demand
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A. Suppose r rises, but Y and P are unchanged. 
What happens to money demand?
B. Suppose P rises, but Y and r are unchanged. 
What happens to money demand?
A C T I V E L E A R N I N G 1
The determinants of MD
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A. Suppose r rises, but Y and P are unchanged. 
What happens to money demand?
r is the opportunity cost of holding money. 
An increase in r reduces money demand: 
households attempt to buy bonds to take 
advantage of the higher interest rate.
Hence, an increase in r causes a decrease in 
money demand, other things equal.
A C T I V E L E A R N I N G 1
Answers
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A C T I V E L E A R N I N G 1
Answers
B. Suppose P rises, but Y and r are unchanged. 
What happens to money demand?
If Y is unchanged, people will want to buy the 
same amount of g&s. 
Since P is higher, they will need more money to 
do so. 
Hence, an increase in P causes an increase in 
money demand, other things equal.
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Equilibrium in the Money Market
According to the theory of liquidity preference:
▪ The interest rate adjusts to balance the supply 
and demand for money. 
▪ There is one interest rate, called the 
equilibrium interest rate, at which the quantity 
of money demanded equals the quantity of 
money supplied.
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How r Is Determined
MS curve is vertical: 
Changes in r do not 
affect MS, which is 
fixed by the Fed.
MD curve is 
downward sloping: 
A fall in r increases 
money demand. 
M
Interest 
rate MS
MD1
r1
Quantity fixed 
by the Fed
Eq’m 
interest 
rate
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How the Interest-Rate Effect Works
AD
(b) The Aggregate Demand Curve
Quantity 
of Output
0
Price 
Level
(a) The Money Market
Quantity 
of Money
Quantity fixed 
by the Fed
0
r1
MSInterest 
Rate
MD1
Y1
P1
MD2
2. increases 
the demand for 
money
1. An increase in the 
price level
P2
3. which increases the 
equilibrium equilibrium rate
r2
4. which in turn reduces the 
quantity of goods and services 
demanded.
Y2
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Monetary Policy and AD
▪ The Fed can shift the AD curve when it changes 
monetary policy. 
▪ 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 MS
➢Contractionary monetary policy: depressing AD by 
keeping the MS lower and interest rates higher
➢Expansionary monetary policy: aimed at expanding 
AD by increasing MS or lowering interest rate
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Y2
AD2
3. which 
increases the 
quantity of goods 
and services 
demanded at a 
given price level. 
1. When 
the Fed 
increases 
the MS
MS2
Y1
P
Quantity 
of Output
0
Price 
Level
AD1
(a) The Money Market
Quantity 
of Money
0
MS1
r1
Interest 
Rate
(b) The Aggregate-Demand Curve
r2
2. the equilibrium 
interest rate falls
MD
A Monetary Injection
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For each of the events below,
- determine the short-run effects on output
- determine how the Fed should adjust the MS and 
interest rates to stabilize output
A. Congress tries to balance the budget by cutting 
govt spending. 
B. A stock market boom increases household wealth.
C. War breaks out in the Middle East, causing oil 
prices to soar.
A C T I V E L E A R N I N G 2
Monetary policy
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A. Congress tries to balance the budget by 
cutting government spending.
This event would reduce AD and output. 
To offset this event, the Fed should increase MS
and reduce r to increase AD.
A C T I V E L E A R N I N G 2
Answers
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A C T I V E L E A R N I N G 2
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B. A stock market boom increases household 
wealth.
This event would increase AD, raising output 
above its natural rate.
To offset this event, the Fed should reduce MS
and increase r to reduce AD.
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How Fiscal Policy Influences AD
▪ Fiscal policy: refers to the government’s choices 
regarding the overall level of government spending 
and taxes.
▪ Expansionary fiscal policy
▪ an increase in G and/or decrease in T
▪ shifts AD right
▪ Contractionary fiscal policy
▪ a decrease in G and/or increase in T
▪ shifts AD left
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Changes in Government Purchases
When the government alters its own purchases of 
goods or services, it shifts the AD curve directly.
2 macroeconomic effects that cause the size of the 
shift in AD to differ from the change in govt 
purchases
▪ The multiplier effect
▪ The crowding-out effect
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Government purchases are said to have a 
multiplier effect on AD.
Each dollar spent by the government can raise 
the AD for g&s by more than a dollar.
1. The Multiplier Effect
Multiplier effect: the additional shifts in AD that 
result when expansionary fiscal policy increases 
income and thereby increases consumer spending
household as wages, profits, interests 
lead to another round of rising income 
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1. The Multiplier Effect
AD1
Quantity of Output
Price
Level
AD2 
1. An increase in government 
purchases of $20 billion 
initially increases AD by $20 
billion
$20 billion
AD3 
2. but the multiplier effect can 
amplify the shift in AD
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How big is the multiplier effect? 
It depends on how much consumers respond 
to increases in income
The formula for the multiplier is:
Spending Multiplier = 1/(1 - MPC)
Marginal propensity to consume (MPC): the 
fraction of extra income that households 
consume rather than save.
1. The Multiplier Effect
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The size of the multiplier depends on MPC. 
E.g., if MPC = 0.5 multiplier = 2
if MPC = 0.75 multiplier = 4
if MPC = 0.9 multiplier = 10
1
1 – MPC
 Y = G
A Formula for the Multiplier
The multiplier
A bigger MPCmeans changes 
in income cause bigger 
changes in C, which in turn 
cause more changes in Y.
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2. The Crowding-Out Effect
▪ Fiscal policy may not affect the economy as 
strongly as predicted by the multiplier. 
▪ A fiscal expansion raises r, which reduces 
investment, and puts downward pressure on AD
Crowding-out effect: the offset in AD that results 
when expansionary fiscal policy raises the interest 
rate and thereby reduces investment spending
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AD3 
4. which in 
turn partly 
offsets the 
initial increase 
in AD
AD1
(b) The Shift in AD
Quantity of Output0
Price 
Level
(a) The Money Market
Quantity 
of Money
Quantity fixed 
by the Fed
0
r1
MD1
MS
Interest 
Rate
1. When an increase in government 
purchases increases AD
AD2 
$20 billion
3. which increases the equilibrium 
interest rate
r2
MD2 
2. the increase 
in spending 
increases MD
2. The Crowding-Out Effect
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▪ When the government increases its purchases 
by $20 billion, AD for goods and services 
could rise by more or less than $20 billion.
▪ Depending on whether the multiplier effect or 
the crowding-out effect is larger.
Changes in Government Purchases
out effect pushes the 
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Changes in Taxes
▪ A tax cut: Households will save some of this 
additional income, but they will also spend some 
of it on consumer → shifting AD to the right. 
▪ The size of the shift is affected by the multiplier 
and crowding-out effects. 
▪ The change in income resulting from a $1 increase 
in T:
Tax Multiplier = - MPC / (1 - MPC)
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Changes in Taxes
▪ It is also determined by the households’ 
perceptions about the permanency of the tax 
change.
▪ A permanent tax cut causes a bigger increase in C 
– and a bigger shift in the AD curve – than a 
temporary tax cut. 
▪ The tax multiplier is smaller than the spending 
multiplier
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A C T I V E L E A R N I N G 3
Exercise
The economy is in recession. 
Shifting the AD curve rightward by $200b 
would end the recession. 
A. If MPC = 0.8 and there is no crowding out, 
how much should government increase G
to end the recession?
B. If there is crowding out, will government need 
to increase G more or less than this amount?
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A C T I V E L E A R N I N G 3
Answers
A. Multiplier = 1/(1 – 0.8) = 5
Increase G by $40b to shift aggregate demand 
by 5 x $40b = $200b. 
B. Crowding out reduces the impact of G on AD.
To offset this, Government should increase G 
by a larger amount. 
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demand and stabilize the economy? 
The government should avoid being the cause of 
economic fluctuations.
Govt should use policy to reduce these 
fluctuations: 
▪ GDP falls below its natural rate, use expansionary 
monetary or fiscal policy to prevent or reduce a 
recession.
▪ GDP rises above its natural rate, use contractionary 
policy to prevent or reduce an inflationary boom.
Active Stabilization Policy
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Automatic Stabilizers
▪ Automatic stabilizers: changes in fiscal policy 
that stimulate AD when economy goes into 
recession, without policymakers having to 
take any deliberate action
▪ Automatic stabilizers include the tax system 
and some forms of government spending.
programs automatically rises,