Monetary and Fiscal Policy Interact Unit 5 Lesson 2 Activity 45 By John Morton Advanced Placement Economics Teacher Resource Manual. National Council on

Monetary and Fiscal Policy Interact

Unit 5 Lesson 2Activity 45

By John MortonAdvanced 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.

• Analyze the effects of combined monetary and fiscal policies on the loanable funds market.

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.

• 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.)

• 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.

AD and ASLoanable Funds Market Money Market

PLInterest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD p

Y

i

I

The Effects of Policy Changes in Multiple Markets

• The AD curve should shift to the right.


PLInterest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD AD1

p

Y

p1

Y1

D1

i1

i

I1 I

• 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.

MD1

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


Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD AD1

p

Y

p1

Y1

D1

i1

i

I1 I

MD1

Increased. AD increased because of the increase in government

spending

B. Employment:

C. Price level:


Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD AD1

p

Y

p1

Y1

D1

i1

i

I1 I

MD1


spending


spending

D. Interest rates:


Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD AD1

p

Y

p1

Y1

D1

i1

i

I1 I

MD1

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

E. Investment:


Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD AD1

p

Y

p1

Y1

D1

i1

i

I1 I

MD1

Decreased because of the increase in interest rates

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


Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD AD1

p

Y

p1

Y1

D1

i1

i

I1 I

MD1

• In the Loanable Funds Market graph, the government’s demand for funds increased the interest rate.

4. Answer the following questions:A. What could the Fed have done to prevent

crowding-out?

A. 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

• 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.

1. 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.


Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

Expansionary Monetary and Fiscal Policy

(A) Real GDP: ? Explain

AD and AS Money MarketInterest Rate

Interest Rate

GDPRLoanable Funds

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

AD1

p1

D1

S1

MS1

MD1

i1

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

Y1


(B) The Price Level: ? Explain


Interest Rate

GDPRLoanable Funds

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

AD1

p1

D1

S1

MS1

MD1

i1

The increase in AD will increase the PL

Y1


(C) Unemployment: ? Explain


Interest Rate

GDPRLoanable Funds

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

AD1

p1

D1

S1

MS1

MD1

i1

The increase in AD will increase employment and output.

Y1


(D) Interest Rates: ? Explain


Interest Rate

GDPRLoanable Funds

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

AD1

p1

D1

S1

MS1

MD1

i1

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.

Y1


(E) Investment: ? Explain


Interest Rate

GDPRLoanable Funds

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

AD1

p1

D1

S1

MS1

MD1

i1

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.

Y1

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.


Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

Contractionary Monetary and Fiscal Policy


Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

AD1 D1 MD1

S1 MS1

p1

Y1


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



Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

AD1 D1 MD1

S1 MS1

p1

Y1

(B) The Price Level: ? Explain

The decrease in AD should result in a lower PL



Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

AD1 D1 MD1

S1 MS1

p1

Y1


Lower output decreases employment on the SRAS curve.



Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

AD1 D1 MD1

S1 MS1

p1

Y1

(D) Interest rates: ? Explain

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.



Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

AD1 D1 MD1

S1 MS1

p1

Y1


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.

3. 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.


Interest Rate

Interest Rate

GDPRLoanable Funds

Money

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

Contractionary Monetary Policy and Expansionary Fiscal Policy


Interest Rate

Interest Rate

GDPRLoanable Funds Money

SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

i1

MS1 S1

D1


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



Interest Rate

Interest Rate


SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

i1

MS1 S1

D1

(B) Price Level: ? Explain

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



Interest Rate

Interest Rate


SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

i1

MS1 S1

D1


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



Interest Rate

Interest Rate


SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

i1

MS1 S1

D1

(D) Interest rates: ? Explain

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



Interest Rate

Interest Rate


SRAS

AD

S

D

MS

MD

p

Y

i

I

PL

i1

MS1 S1

D1


The increase in interest rates will tend to decrease investments.

Documents

Monetary and Fiscal Policy Interact Unit 5 Lesson 2 Activity 45 By John Morton Advanced Placement Economics Teacher Resource Manual. National Council on