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Monetary and Fiscal Policy Interact. Unit 5 Lesson 2 Activity 45 By John Morton Advanced Placement Economics Teacher Resource Manual . National Council on Economic Education, New York, N.Y. Objectives. Practice analytical skills with AD and SRAS model and the money market.

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monetary and fiscal policy interact

Monetary and Fiscal Policy Interact

Unit 5 Lesson 2

Activity 45

By John Morton

Advanced Placement Economics Teacher Resource Manual. National Council on Economic Education, New York, N.Y

objectives
Objectives
  • Practice analytical skills with AD and SRAS model and the money market.
  • Analyze the effects of combined monetary and fiscal policies on the loanable funds market.
introduction
Introduction
  • This lesson continues an examination of the interaction between monetary and fiscal policy in the short-run.
  • It examines the impact of monetary and fiscal policy on output, the price level, unemployment, interest rates and investment.
  • Your success on the AP Exam depends on your ability to explain why economic variables are affected.
slide4
Activity 45 provides you with an opportunity to work through the short-run effects of monetary and fiscal policy on important macroeconomic variables.
  • You will continue to use the loanable funds market and the money market in this activity. (The following slides are not on your activity sheet.)
the effects of policy changes in multiple markets
The Effects of Policy Changes in Multiple Markets

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

  • Suppose that, in response to the economic situation, the federal government decides to increase its spending without increasing taxes and the Fed keeps the money supply constant. There is no Barro-Ricardo effect.
  • Explain what would happen in the three markets shown above.

MS

SRAS

S

p

i

MD

AD

D

Loanable Funds

Y

GDPR

I

Money

slide6

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS

SRAS

S

i1

p1

  • The AD curve should shift to the right.

p

i

MD1

MD

D1

AD1

AD

D

Loanable Funds

Y

Y1

GDPR

I

I1

Money

  • Increase the demand for loanable funds by shifting the curve to the right.
  • The demand for money should also shift to the right.
  • The interest rates in the money market and loanable funds should be equal.
slide7

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

MS

SRAS

S

i1

p1

  • What happened to each of the following variables and why:
    • Output (real GDP):

p

i

MD1

MD

D1

AD1

AD

D

Loanable Funds

Y

Y1

GDPR

I

I1

Money

Increased. AD increased because of the increase in government spending

slide8

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

MS

SRAS

S

i1

p1

  • Employment:
  • Price level:

p

i

MD1

MD

D1

AD1

AD

D

Loanable Funds

Y

Y1

GDPR

I

I1

Money

Increased. AD increased because of the increase in government spending

Increased. AD increased because of the increase in government spending

slide9

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

MS

SRAS

S

i1

p1

  • Interest rates:

p

i

MD1

MD

D1

AD1

AD

D

Loanable Funds

Y

Y1

GDPR

I

I1

Money

Increased. With the money supply held constant, the demand for money increased or the demand for loanable funds increased.

slide10

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

MS

SRAS

S

i1

p1

  • Investment:

p

i

MD1

MD

D1

AD1

AD

D

Loanable Funds

Y

Y1

GDPR

I

I1

Money

Decreased because of the increase in interest rates

slide11

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

MS

SRAS

S

i1

p1

  • Was there crowding-out present in the above graphs?

p

i

MD1

MD

D1

AD1

AD

D

Loanable Funds

Y

Y1

GDPR

I

I1

Money

  • In the Loanable Funds Market graph, the government’s demand for funds increased the interest rate.
slide12
Answer the following questions:
    • What could the Fed have done to prevent crowding-out?
    • Are there certain conditions when the Fed should or should not prevent crowding-out?

The Fed could use expansionary monetary policy; thus the government’s demand for funds would not result in an increase in interest rates.

If the economy were experiencing a recession, the Fed would want to prevent crowding-out, but if the economy were at or near full employment and government spending increased, the Fed might not want to prevent crowding-out.

graphing monetary and fiscal policy interactions
Graphing Monetary and Fiscal Policy Interactions
  • Illustrate the short-run effects for each monetary and fiscal policy combination using AD and AS curves, the money market and the loanable funds market.
  • Once again, assume that there are no changes in the foreign sector.
  • Circle the appropriate symbols (↑ for increase, ↓ for decrease, and ? for uncertain), and explain the effect of the policies on real GDP, the price level, unemployment, interest rates and investment.
slide14
The unemployment rate is 10%, and the CPI is increasing at a 2% rate. The federal government cuts personal income taxes and increase its spending. The Fed buys bonds on the open market.

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS

SRAS

S

p

i

MD

AD

D

Loanable Funds

Y

GDPR

I

Money

expansionary monetary and fiscal policy
Expansionary Monetary and Fiscal Policy

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS

MS1

  • Real GDP: ? Explain

SRAS

S

S1

p1

i1

p

i

AD1

MD1

D1

MD

AD

D

Loanable Funds

Y

Y1

GDPR

I

Both policies are expansionary: C, G & I will all increase.

expansionary monetary and fiscal policy16
Expansionary Monetary and Fiscal Policy

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS

MS1

(B) The Price Level: ? Explain

SRAS

S

S1

p1

i1

p

i

AD1

MD1

D1

MD

AD

D

Loanable Funds

Y

Y1

GDPR

I

The increase in AD will increase the PL

expansionary monetary and fiscal policy17
Expansionary Monetary and Fiscal Policy

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS

MS1

(C) Unemployment: ? Explain

SRAS

S

S1

p1

i1

p

i

AD1

MD1

D1

MD

AD

D

Loanable Funds

Y

Y1

GDPR

I

The increase in AD will increase employment and output.

expansionary monetary and fiscal policy18
Expansionary Monetary and Fiscal Policy

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS

MS1

(D) Interest Rates: ? Explain

SRAS

S

S1

p1

i1

p

i

AD1

MD1

D1

MD

AD

D

Loanable Funds

Y

Y1

GDPR

I

Fiscal policy would result in an increase in interest rates; monetary policy would result in lower interest rates. The net effect depends on the relative strength of the two policies. The graph here shows a slight increase in interest rates; the effect on interest rates is indeterminate.

expansionary monetary and fiscal policy19
Expansionary Monetary and Fiscal Policy

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS

MS1

(E) Investment: ? Explain

SRAS

S

S1

p1

i1

p

i

AD1

MD1

D1

MD

AD

D

Loanable Funds

Y

Y1

GDPR

I

Because we can’t tell what happens to interest rates, we can’t say what happens to investment because of changes in the interest rate.

slide20
2. The unemployment rate is 6%, and the CPI is increasing at a 9% rate. The federal government raises personal income taxes and cuts spending. The Federal Reserve sells bonds on the open market.

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS

SRAS

S

p

i

MD

AD

D

Loanable Funds

Y

I

GDPR

Money

contractionary monetary and fiscal policy
Contractionary Monetary and Fiscal Policy

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS1

MS

S1

(A) Real GDP: ? Explain

SRAS

S

p

i

p1

MD

AD

D

AD1

D1

MD1

Loanable Funds

Y1

Y

GDPR

I

Money

Decreased AD should lower GDP somewhat. AD decreases because of contractionary monetary and fiscal policy.

contractionary monetary and fiscal policy22
Contractionary Monetary and Fiscal Policy

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS1

MS

S1

(B) The Price Level: ? Explain

SRAS

S

p

i

p1

MD

AD

D

AD1

D1

MD1

Loanable Funds

Y1

Y

GDPR

I

Money

The decrease in AD should result in a lower PL

contractionary monetary and fiscal policy23
Contractionary Monetary and Fiscal Policy

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS1

MS

S1

(C) Unemployment: ? Explain

SRAS

S

p

i

p1

MD

AD

D

AD1

D1

MD1

Loanable Funds

Y1

Y

GDPR

I

Money

Lower output decreases employment on the SRAS curve.

contractionary monetary and fiscal policy24
Contractionary Monetary and Fiscal Policy

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS1

MS

S1

(D) Interest rates: ? Explain

SRAS

S

p

i

p1

MD

AD

D

AD1

D1

MD1

Loanable Funds

Y1

Y

GDPR

I

Money

The Fed decreases the money supply, which should result in an increase in interest rates. The increase in taxes and decrease in government spending result in a decrease in interest rates since the demand for loanable funds by the government should decrease. The demand for money decrease because of the decrease I real GDP. Interest rates will be higher if the decrease in demand is less than the decrease in supply in the money market. The interest rate effect is indeterminate.

contractionary monetary and fiscal policy25
Contractionary Monetary and Fiscal Policy

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS1

MS

S1

(E) Investment: ? Explain

SRAS

S

p

i

p1

MD

AD

D

AD1

D1

MD1

Loanable Funds

Y1

Y

GDPR

I

Money

If interest rates are higher; there would be a decrease in the level of investment. If interest rates are lower, there would be an increase.

slide26
The unemployment rate is 6%, and the CPI is increasing at a 5% rate. The federal government cuts personal income taxes and maintains current spending. The Fed sells bonds on the open market.

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

S

MS

SRAS

p

i

AD

D

MD

Loanable Funds

Y

I

GDPR

Money

contractionary monetary policy and expansionary fiscal policy
Contractionary Monetary Policy and Expansionary Fiscal Policy

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS1

MS

(A) Real GDP: ? Explain

S1

SRAS

i1

S

p

i

D1

AD

MD

D

Loanable Funds

Y

GDPR

I

Money

The combined effect on AD is impossible to predict. The fiscal policy is expansionary, and the monetary policy is contractionary.

contractionary monetary policy and expansionary fiscal policy28
Contractionary Monetary Policy and Expansionary Fiscal Policy

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS1

MS

(B) Price Level: ? Explain

S1

SRAS

i1

S

p

i

D1

AD

MD

D

Loanable Funds

Y

GDPR

I

Money

The impact on the price level is impossible to predict given the contradicting monetary and fiscal policies.

contractionary monetary policy and expansionary fiscal policy29
Contractionary Monetary Policy and Expansionary Fiscal Policy

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS1

MS

(C) Unemployment: ? Explain

S1

SRAS

i1

S

p

i

D1

AD

MD

D

Loanable Funds

Y

GDPR

I

Money

The impact on output and, hence, employment is impossible to predict given the contradicting monetary and fiscal policies.

contractionary monetary policy and expansionary fiscal policy30
Contractionary Monetary Policy and Expansionary Fiscal Policy

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS1

MS

(D) Interest rates: ? Explain

S1

SRAS

i1

S

p

i

D1

AD

MD

D

Loanable Funds

Y

GDPR

I

Money

Interest rates will rise because of the increased demand for and reduced supply of loanable funds.

contractionary monetary policy and expansionary fiscal policy31
Contractionary Monetary Policy and Expansionary Fiscal Policy

Loanable Funds Market

Money Market

AD and AS

Interest Rate

Interest Rate

PL

MS1

MS

(E) Investment: ? Explain

S1

SRAS

i1

S

p

i

D1

AD

MD

D

Loanable Funds

Y

GDPR

I

Money

The increase in interest rates will tend to decrease investments.