CHAPTER 27: MONETARY POLICY AND FISCAL POLICY INTERACTIONS

(uses AD/AS model, Md/Ms model and IE functions)

FISCAL POLICY: 1^st and 2^nd round effects

first round effects:

n as G increases, AE increases and AD curve shifts right (with a multiplier effect), increasing equilibrium Y and P.

second round effects: follows change in Y and change in P.

n the increase in Y implies Md increases (shifts right), raising equilibrium interest rates, IE decreases and AD shifts back to the left somewhat with multiplier.

n the increase in P implies (Ms/P) decreases, i.e, money supply curve shifts left raising equilibrium interest rates, decreasing IE and move upwards along AD curve reducing Y.

Crowding Out:

n expansionary fiscal policy (increasing G or decreasing Taxes) results in r increasing (interest rates increase) which ‘crowds out’ (reduces) Investment expenditures (I) from the private sector

n and if increased G is spent on goods and services rather than K stock purchases, the economy ends up with a lower K stock too

n in addition, as G increases and r increases, the Canadian dollar will appreciate which lowers net exports (NX falls). Therefore, increased G will also ‘crowd out’ net exports.

Monetary Policy: 1^st and 2^nd round effects

first round effects:

n as money supply increases (expansionary monetary policy), interest rates fall, IE increases and AD shifts right with a multiplier effect. Equilibrium P and Y both increase.

Second round effects of Y increasing:

n as Y increases, Md increases (shifts right), raising equilibrium interest rates, lowering IE, and shifting AD curve back to the left somewhat (with a multiplier effect)

n as P increases: real Money supply (Ms/P) falls shifting leftward, raising equilibrium interest rates, lowering IE and causes a movement upward along AD to the new equilibrium.

Effectiveness of Fiscal and Monetary Policy:

n depends on the responsiveness of : DIE due to Dr (i.e., slope of IE curve) AND

n depends on the responsiveness of: Md to a Dr (i.e., slope of Md function).

n a steep Md curve and a relatively flat IE curve will make monetary policy very effective in terms of being able to change equilibrium Y. But this combination of a steep Md and a relatively flat IE curve will render fiscal policy less effective in terms of changing equilibrium Y.

n alternatively, a flat Md curve and a relatively steep IE curve will make fiscal policy more effective than monetary policy in terms of changing equilibrium Y.