Econ 13, Foldvary

Mankiw, 21. Monetary and fiscal policy and aggregate supply and demand.

The British economist John Maynard Keynes started a new macroeconomic school of thought in the 1930s named after him.

(Mankiw is a Keynesian)

The Keynesian school emphasizes short-run demand-side policy.

This includes the doctrine of liquidity preference, that folks demand less money at higher interest rates.

The hypothesis of liquidity preference.

The proposition that the interest rate adjusts to bring money supply and demand into balance. (Keynesian)

The alternative hypothesis: the price level equilibrates the demand for money to its supply.

The opportunity cost of holding money is the foregone interest income.

An increase in the interest rate increases the opportunity cost of holding money, so less money is demanded.

This creates a downward sloping demand for money, with the interest rate on the vertical axis.

The problem with this is, first, higher interest rates can induce interest-paying checking accounts, so the demand for money

would not change.

Second, even if people don't want to hold money, the money does not go away.

Somebody is going to hold it.

Either money-market funds will pay higher interest, or else, the price of assets such as real estate or stocks will rise to

absorb the extra money.

This is what happened during the late 1970s and early 1980s, when interest rates were high.

Bond issuers respond to the surplus of money by lowering the interest rate they offer?

Nonsense!

When more people want to buy bonds, the price rises to match the market rate of return.

Suppose the Fed increases M.

This temporarily lowers the real interest rate and in the short run increases AD.

Keynesians say the interest rate falls in order to induce people to hold more money.

There is more investment, and GDP grows.

That is Keynesian theory, which may not necessarily apply to the real economy.

See p. 466.

Mankiw says the most important reason for the downward slope of AD is the interest rate effect: a lower price level creates

greater effective wealth and some of that is saved.

But since most of the purchasing power is spent for consumption, the wealth effect is really greater.

Mankiw: Because money holdings are a small part of household wealth, the wealth effect is the least important of the three.

Is he right?

A household usually only holds a small amount of currency, but it can have substantial amounts of funds in savings and

money-market funds.

Also, when it spends money, what matters is MV, not just M.

When income is spent, the amount of goods does depend on the price level.

Increase in money can temporarily reduce interest rates and increase investment, but later interest rates rise again.

The hypothesis of liquidity preference.

The proposition that the interest rate adjusts to bring money supply and demand into balance. (Keynesian)

The alternative hypothesis: the price level equilibrates the demand for money to its supply.

The opportunity cost of holding money is the foregone interest income.

An increase in the interest rate increases the opportunity cost of holding money, so less money is demanded.

This creates a downward sloping demand for money, with the interest rate on the vertical axis.

The problem with this is, that even if people don't want to hold money, the money does not go away. Somebody is going to

hold it.

Either money-market funds will pay higher interest, or else, the price of assets such as real estate or stocks will rise to

absorb the extra money.

This is what happened during the late 1970s and early 1980s, when interest rates were high.

P. 449: bond issuers respond to the surplus of money by lowering the interest rate they offer.

Nonsense! When more people want to buy bonds, the price rises to match the market rate of return.

Mankiw and I agree on the effects of monetry policy: p. 452.

When the Fed increases the money supply, it lowers the interest rate and in the short run increases AD.

The Fed targets interest rates, especially the federal funds rate.

That is easier than trying to control one of the money-supply rates.

It adjusts the money supply to keep interest rates at that level.

See p. 467.

Under free banking, the money policy is to leave the money supply and interest rates to the market.

Fiscal policy refers to government revenues and spending.

If the government spends more money, does this increase AD?

In the long run, only if the funds come from abroad and there are idle resources that get employed.

If the funds are domestic, more government spending just shifts spending to the government sector.

Only if there are rigid prices and idle resources would AqS increase.

When G rises, does AD shift out?

If the funds come from taxes, C and I fall, offsetting the increase in G.

If G is funded from abroad does AD rise.

AD could also rise in the short term if wages or prices are stuck.

G can also come from borrowing.

The crowding out effect is the reduction in private spending caused by an increase in government spending, shifting funds by

taxing or borrowing.

Multiplier effect: initial spending gets multiplied as those who get paid spend their money in turn.

It is also referred to as the investment accelerator.

Whether it occurs depends on the extent of idle resources.

Keynesian theory also has a concept called the marginal propensity to consume, the fraction of income that goes to

household purchases of goods.

Keynesians think this is a big deal.

Japan has tried expanding government sending to increase growth, to little effect, during the past 10 years.

When G rises, does AD shift out?

If the funds come from taxes, C and I fall, offsetting the increase in G.

If G is funded from abroad does AD rise.

AD could also rise in the short term if wages or prices are stuck.

The Keynesian multiplier (p. 471).

Y = C + I + G

C = b(Y-T)

Y = bY -bT + I + G

Y-bY = I + G - bT

Y(1-b) = I + G -bT

Y=(I+G-bT)/(1-b)

If b rises, 1-b falls, and Y increases.

Or, more simply and basically:

Y=bY + G

Savings reduces Y!

Y-bY = G

Y(1-b) = G

Y = G/(1-b)

We can increase GDP simply by saving less money! So say Keynesians. Do you agree?

Japan has been trying to stimulate its economy since 1990 with fiscal and monetary expansion, and it has not worked.

Tax cut has both supply and demand side effects.

The economy has automatic stabilizers, such as lower taxes when the economy is in recession, while spending rises.

A reduction in income taxes has a supply-side and a demand-side effect.

The supply side effect comes from greater incentives to produce and invest. The demand-side effect comes from greater

private spending, as with the current tax rebates. But it can be offset by lower government spending.

Government policy can be activist, reacting to current news, or passive, based on permanent rules. Critics of activist policy

say government does not have sufficient knowledge of how best to react, and policy can more likely crowd out than

stimulate output.

Question for stabilization policy: why is the economy unstable in the first place?

Does policy treat the cause or just the effects?

A free-market macroeconomic policy would include free banking and taxes mainly on rent and pollution. In my analysis,

that would stabilize the economy while maximizing both growth and environmental protection.