1. Chapter 35
!
Monetary Policy
Fiscal Policy
and
Aggregate Demand

2. Key Terms
theory of liquidity preference
fiscal polices
multiplier effect
crowding-out effect
automatic stabilizers
!

3. Economic Cycle

4. Aggregate Demand
Wealth Effect
Interest-Rate Effect
Exchange-Rate Effect

5. John Maynard Keynes
(1883 - 1946)
!
Father of Macroeconomics
!
The GeneralTheory of
Employment,
Interest and Money
!
The ideas of economists and political
philosophers are more powerful than
commonly understood; indeed the
world is ruled by little else.

6. Theory of Liquidity
Preference
Interest rates adjust to
bring money supply and
money demanded into
balance

7. Interest Rates
Nominal = Real + Inflation
!
If inflation is zero, then
nominal = real

8. Money Supply
Discount Rate
Bond Market
Reserve Ratio

9. Interest
Rate
Quantity of MoneyMD1
Money Market
MD2
r1
r2
Money
Supply
Money
Demand
Quantity fixed
by the Central
Bank
Equilibrium
Interest
Rate

10. Liquidity Theory
1. Money Supply is fixed by central bank with
policy tools (Debt Instrument Market, Discount
Rate, Reserve Requirement)
2. Money Demand - Liquidity - Interest rate is
the opportunity cost of holding money.
3. Equilibrium pressures

11. Interest
Rate
Quantity of Money
Money Market
r2
Money
Supply
Money
Demand
Quantity fixed
by the Central
Bank
r1
r3

12. Money
Demand
Interest
Rate
Quantity of Money
Money Market
r
Money
Supply
r1
r3

13. Interest
Rate
1. Price level increases
2. Increases demand for money
3. Increases interest rate
4. Reduces quantity demand of output
Money Market
r2
Money
Supply
Money
Demand
Quantity
fixed by the
Central Bank
r1
Price
Level
P2
Aggregate
Demand
OutputY2
P1
Y1
Aggregate Demand

14. Fiscal Policies
Level of government
spending and taxing

15. Multiplier Effect
Additional shifts in
aggregate demand due to
expansionary government
spending

16. Marginal Propensity to Consume
MPC
New income = spend + save
How much do you spend?
75 percent
Then you will be saving 25 percent

17. Marginal Propensity to Consume
plus
Marginal Propensity to Save
equals one
!
MPC + MPS = 1
1- MPS = MPC
1- MPC = MPS

18. Earn Spend Total Spending
1 100.0 75.0 75.0
2 75.0 56.3 131.3
3 56.3 42.2 173.4
4 42.2 31.6 205.1
5 31.6 23.7 228.8
6 23.7 17.8 246.6
7 17.8 13.3 260.0
8 13.3 10.0 270.0
9 10.0 7.5 277.5
10 7.5 5.6 283.1
11 5.6 4.2 287.3
Multiplier
!
1/(1-MPC)
!
Remember
1-MPC = MPS
Therefore
Multiplier
also
1/MPS

19. MPC MPS Total Spending
1.00 0.00 infinite
0.90 0.10 10.00
0.80 0.20 5.00
0.75 0.25 4.00
0.60 0.40 2.50
0.50 0.50 2.00
0.40 0.60 1.67
0.30 0.70 1.43
0.25 0.75 1.33
0.10 0.90 1.11
0.50 0.50 2.00
Multiplier
!
1/(1-MPC)
!
Remember
1-MPC = MPS
!
Therefore
Multiplier
also
1/MPS

20. Multiplier Effect
1.Works with C, I, G, and
NX
2. Goes both ways

21. Where does the money
come from?
Tax
Borrow
Reduces Income
Increases interest

22. Crowding-Out can be
larger than the
Multiplier
Aggregate Demand shifts
left

23. Crowding-out Effect
Offsetting aggregate
demand when fiscal
expansion raises interest
rates and reduces spending

24. Price
Level
Quantity of Output
PL
Y3 Y1 Y2
Government Spending
Multiplier Effect
Government Spending
Crowding-Out Effect
Taxes & Borrowing

25. Automatic Stabilizers
Changes in fiscal policy that
stimulate aggregate demand
when the economy goes
into a recession

26. Physical Financial Human Intellectual Cultural Total
Saudi
Arabia
Qatar
U.A. E.
Jordan
Kuwait
Iraq
Egypt
Capital Analysis Scale 1-10 each category
1=lowest, 10=highest