Economics: What in the World is Monetary and Fiscal Policy?

This chapter really goes hand in hand with the previous chapter. I don't know why Mankiw separated them like this.

Recall the wealth effect, interest rate effect, and exchange rate effect that explains why the aggregate demand curve slopes downward. These 3 effects occur simultaneously to increase quantity demanded when price level falls and decrease quantity when price level rises. The interest rate effect is most important for the U.S.

Now we will define the theory of liquidity preference. We will make another graph. In this graph, money supply is vertical, since the supply is set and controlled by the Fed. The money demand slopes downward explained in the theory of liquidity preference by interest rate. If interest rate is high, one holds less money and saves it, thus reducing money quantity demanded. If interest rate is low, one holds more money (discourages saving) so increases money quantity demanded. So the interest rate goes on the y-axis and the quantity of money goes on the x-axis. The intersection of the money supply and money demand is the equilibrium interest rate.

An example of using the theory of liquidity preference: if price level increases, the quantity of goods demanded decreases. Money demanded increases to counteract the rising prices which then reduces interest rates.

If money supply increases, equilibrium interest rate decreases. This encourages investment and shifts the aggregate demand curve.

So when the Fed wants to change the economy by changing aggregate demand, the monetary policies they make can be described as changing interest rates or changing the money supply.

Then what is fiscal policy and how does that affect the economy? Certain policies that the government decides upon that affect long run economic growth are considered fiscal.

One fiscal policy is changing government purchases. If the government spends $20 billion domestically on fighter planes, the aggregate demand curve will shift right. This shift may not necessarily be exactly 20 billion. Because of the multiplier effect, the impact could be even greater. The multiplier effect happens because increased demand causes increases in wages and profits which encourage more and more spending in different rounds.

The MPC (marginal propensity to consume) is the fraction of extra income people decide to save. If the MPC is 3/4, then an increase of 20 billion yields 20 billion / (1 - 3/4) = 80 billion total impact. This 1/(1-x) formula comes from the infinite sum of a geometric series.

The multiplier effect extends to more than government purchases. It includes recessions and stock market booms and more.

Another side effect is the crowding out effect. This occurs because an increase in demand also increases spending and reduces saving. As saving reduces, interest rates rise and investment is discouraged. This effect makes shifts in aggregate demand less.

Another fiscal policy is tax changes. Tax cuts shift the demand right and tax raises shift the demand left. This includes investment tax credit too.

Should the government use policy to stabilize the economy? Currently, the U.S. government does, according to the Employment Act of 1946. It states that government should avoid being the cause of fluctuations and also respond to changes in the economy to stabilize aggregate demand.

Keynes argues that aggregate demand fluctuates from waves of optimism and pessimism. He says that government should always counteract these waves with economic policy.

Others argue against active stabilization of economy. The primary argument is that changes in policy usually come to late, and instead cause more fluctuation. These lags happen because fiscal policies must be confirmed by legislature and the president and monetary policy takes at least six months to have effects on employment or output.

Some policies act as automatic stabilizers. For example, the tax system is an automatic stabilizer. You pay less tax if you spend/earn less and pay more tax if you spend/earn more. Government spending on welfare and other income supports also acts as an automatic stabilizer. When in recession, spending increases on these supports which increases aggregate demand and counteracts the recession.

Although these automatic stabilizers are not strong enough to stop recessions completely, they have reduced the volatility of output and employment greatly. This is why many people argue against a balanced budget for the government that would eliminate the automatic stabilizers we have already.