The Influence of Monetary & Fiscal Policy on Aggregate Demand Flashcards
Monetary Policy
Control of money supply by central bank
Fiscal policy
Government spending and taxation by minister of finance
Least important effect to explain the downward slope of the Aggregate Demand curve
Wealth effect
Most important effect to explain the downward slope of the Aggregate Demand Curve
Interest Rate Effect
Which interest rate is explained through the theory of liquidity preference?
Both real and nominal interest rates. Only separated by a constant inflation rate in this case. If real interest rate falls, so does nominal interest rate.
Theory of liquidity preference
Keynes’ theory that the interest rate adjusts to bring money demand and money supply into balance
Most liquid asset available
Money - as it is the economy’s medium of exchange
Liquidity
the ease to which an asset can be converted to the economy’s medium of exchange.
Opportunity cost of holding money
Interest rate
When you hold wealth in the form of cash in your wallet, instead of interest-bearing bonds…
you lose interest that you could have earned.
Although many factors determine the interest rate, the one emphasized by the theory of liquidity preference is
Interest rate
Reason for negative slope of money demand
An increase in interest rate raises the cost of holding money. As a result, this reduces the quantity of money demanded.
Money demand curve shifters
Increasing price level or Real GDP increases money demand
Decreasing price level or Real GDP decreases money demand
When money supply increases,
interest rate decreases
For a money injection in a small open economy, how should the money demand in the end adjust?
to equate the Canadian interest rate with the world interest rate.
In a small open economy with a flexible exchange rate, a money injection leads to what?
a decrease in the exchange rate (depreciation of currency), which leads to an increase in net exports. AD curve is pushed further right.
Where is monetary policy most effective?
In an open economy with a flexible exchange rate.
Bank of Canada has maintained a policy of what type of exchange rate?
Flexible exchange rate
Monetary policy is ineffective when…
Exchange rate is fixed
For money injections, the Bank of Canada would do what to keep exchange rates fixed?
Sell foreign currencies
Two macroeconomic effects that cause the size of the AD curve shift to differ from the change in government purchases:
Multiplier Effect and Crowding out effect
Multiplier Effect
Also known as spending multiplier. Additional shifts in aggregate demand that result when expansionary fiscal policy increases income and therefore consumer spending.
Marginal Propensity to Consume (MPC)
The fraction of extra income that a household consumes rather than saves.
Marginal Propensity to Import (MPI)
The fraction of extra income that a household spends on imports.
Spending multiplier formula in closed economy
1 / (1 - MPC)
Spending multiplier formula in an open economy
1 / (1 - MPC + MPI)
Crowding out effect on investment
The offset in aggregate demand that results when expansionary fiscal policy raises interest rates and therefore reduces investment spending.
Fiscal policy on small open economy with flexible exchange rate has what effects?
None
Two types of crowding out effects for fiscal policy
Crowding out on investment and crowding out on net exports.
What happens when fiscal expansion is applied to a small open economy with a fixed exchange rate?
Central bank increases money supply to prevent exchange rate from changing. This lowers the interest rate back to the world interest rate. As there were no changes to the interest rate and exchange rate, crowding out disappears.
Fiscal policy is more effective in a closed or open economy?
Like monetary policy, fiscal policy is more effective in an open economy, albeit with a fixed exchange rate.
In Canada, who determines the exchange rate policy?
Bank of Canada
Current minister of finance (fiscal policy)
Joe Oliver
Why is coordination of monetary and fiscal policy important?
For fiscal policy to have a lasting effect on the position of the aggregate demand curve, the bank of Canada must choose the appropriate exchange rate policy.
Two important instruments of fiscal policy:
Level of government purchases and level of taxation.
Keynes argued that aggregate demand fluctuates because of what?
Animal spirits - largely irrational waves of optimism and pessimism
The Case for an Active Stabilization Policy
Keynes argued that the government should actively stimulate aggregate demand when it appeared insufficient to maintain production at its full employment level.
The Case against an Active Stabilization Policy
Fiscal and Monetary Policies affect the economy with a long lag.
Automatic Stabilizers
Changes in fiscal policy that stimulate aggregate demand when the economy goes into recession, without any deliberate actions taken by policy makers.
Examples of Automatic Stabilizers
Tax System, Unemployment Insurance, Welfare Benefits, Flexible Exchange rate
Decrease money supply to…
Slow the economy down and to reduce inflationary pressure
GDP deflator equation
nominal GDP / real GDP * 100
Inflation rate calculation
(New - Old) / Old * 100
