MONETARY AND FISCAL

POLICY
 Overview

The government has four primary objectives when it

intervenes in the macro economy:
(2) Promote full employment (high employment)
(3) Promote price stability (low inflation)
(4) Promote Economic Growth
(5) Promote the Stability of Financial Markets
 Overview

The government pursues those objective through its

use of fiscal and monetary policy.
 Fiscal Policy

• Fiscal Policy: The use of government spending

and taxation to promote price stability, full
employment and economic growth
• Fiscal policy influences saving, investment, and
economic growth in the long run.
• In the short run, fiscal policy primarily affects the
aggregate demand.
 Fiscal Policy and Full Employment
During a recession, the
LRAS government can stimulate the
P economy by increasing
government spending or
decreasing taxes.

SRAS

P2

P1

AD2
AD1

Y1 Yp Real GDP
 Fiscal Policy and Price Stability
LRAS During an inflationary period, the
P government can contract the
economy by decreasing government
spending or increasing taxes.

SRAS

P1

P2

AD1
AD2

Yp Y1 Real GDP
 Monetary Policy

• Monetary Policy: The actions the Federal Reserve

takes to manage the money supply and interest
rates to pursue policy objectives.
• In the short-run, monetary policy affects aggregate
demand through its effect on interest rates.
 Monetary Policy Targets

• Monetary Policy Targets: Variables the Fed

uses to implement its goals of price stability, low
unemployment, and economic growth.
• The two main monetary policy targets are:
3) The money supply
4) The interest rate

The Fed typically uses the interest rate as its main

policy target.
 The Demand for Money

• The money demand curve illustrates the

relationship between the amount of money
individuals want to hold and the interest rate.
• The quantity of money demanded is inversely
related to the interest rate.
– When interest rates rise, the opportunity cost of holding
money increases.
 The Money Demand Curve
Interest Rate The money demand curve slopes
downward: as interest rates rise, the
opportunity cost of holding money
increases and hence the quantity of
money demanded decreases

r2

r1

Money Demand

M2 M1 Quantity of Money
 The Money Supply
The money supply is controlled by the Fed through:
• Open-market operations (buying and selling of
Treasury securities).
• Changing the reserve requirements
• Changing the discount rate

Because it is fixed by the Fed, the quantity of money

supplied does not depend on the interest rate.
The fixed money supply is represented by a vertical
supply curve.
 The Money Supply Curve
Interest Rate
Money Supply Because the Fed controls the
money supply, the money
supply is independent of the
interest rate and hence the
money supply curve is vertical

M1 Quantity of Money
 Equilibrium in the Money Market
Interest Rate Money Supply

The demand and supply of money

determines the equilibrium interest rate in
the economy. Equilibrium in the money
market occurs where the quantity of
money demanded equals the quantity of
money supplied.
r1

Equilibrium

Money Demand

M1 Quantity of Money
 An Increase in the Money Supply
Interest Rate MS1 MS2
If the Fed increases the
Money supply (buys
Treasury securities), the
money supply curve shifts
r1
right. As a result, interest
rates fall.

r2

Money Demand

M1 M2 Quantity of Money
 A Decrease in the Money Supply
Interest Rate MS2 MS1
If the Fed decreases the
money supply (sells
Treasury securities), the
money supply curve shifts
r2
left. As a result, interest
rates rise.

r1

Money Demand

M2 M1 Quantity of Money
 The Federal Funds Rate
• Recall that the Fed can use either the money supply
or the interest rate as its monetary policy target.

• Since 1990, the Fed has increased its reliance on

interest rate targeting.

• The interest rate the Fed targets for monetary policy

purposes is known as the federal funds rate.

• Federal Funds Rate: The interest rate banks charge

each other for overnight loans.
 The Federal Funds Rate
• Note that the federal funds rate is NOT set by the
Fed.
• Instead, the Fed announces a target for the federal
funds rate and then uses it control over open market
operations (buying and selling of Treasury
securities) to insure they hit their target.
• When the Fed lowers the federal funds rate, other
interest rates tend to also decline (mortgage rates,
etc).
• Similarly, when the Fed increases the federal funds
rate, other interest rates tend to rise.
 Monetary Policy and the Economy in the
Short-Run
• Expansionary Monetary Policy: When the Fed
increases the money supply and decreases interest
rates to increase real GDP.

• Contractionary Monetary Policy: When the Fed

decreases the money supply and increases interest
rates to reduce inflation.
 Monetary Policy and the Economy in the
Short-Run
• Monetary policy affects the economy in the short-
run through its affect on interest rates and
aggregate demand.
• When the Fed increases the money supply (lowers
the federal funds rate), interest rates fall.
• The fall in interest rates stimulates household
consumption and firm investment. As a result, the
aggregate demand curve shifts right.
 An Increase in the Money Supply
Interest Rate MS1 MS2
If the Fed increases the
Money supply, the money
supply curve shifts right.
As a result, interest rates
r1
fall.

r2

Money Demand

M1 M2 Quantity of Money
 An Increase in the Money Supply
… Lower interest rates cause
LRAS
the aggregate demand curve to
P shift right. As a result, real
GDP and the aggregate price
level rise.

SRAS

P2

P1

AD2
AD1

Y1 Yp Real GDP
 Monetary Policy Example

Suppose the Fed is worried about inflation.

In response, the Fed could lower the money supply
by:
(3) Selling Treasury securities (increase the federal
funds rate)
(4) Increasing the discount rate
(5) Increasing the required reserve ratio
 A Decrease in the Money Supply
Interest Rate MS2 MS1
If the Fed decreases the
money supply, the money
supply curve shifts left. As
a result, interest rates rise.
r2

r1

Money Demand

M2 M1 Quantity of Money
 A Decrease in the Money Supply
LRAS … the rise in interest rates causes
P the aggregate demand curve to shift
left. As a result, real GDP and the
aggregate price level fall.

SRAS

P1

P2

AD1
AD2

Yp Y1 Real GDP
 Summary of How Monetary Policy Works

Expansionary and Contractionary

Monetary Policies
 Monetary Policy and the 2001 Recession

Events Surrounding the 2001 Recession:

3. End of the Dot-Com bubble in 2000. Stock

prices fell about 25% between August 2000 and
August 2001.
4. Decline in investment spending staring in 2001.
5. 9/11 Terrorist attacks. Terrorists attacks reduced
consumer confidence and increased firm
uncertainty.
 Cause of the 2001 Recession
LRAS The Dot-com bust, 9/11 and the
decline in firm investment
P caused the aggregate demand
curve to shift left.

SRAS

P1

P2

AD1
AD2

Y2 Y1 Real GDP
 The Fed’s Response

In response to the events surrounding the 2001

recession the Fed increased the money supply
by:
(2) Lowering the discount rate
(3) Buying Treasury securities (lowering the federal
funds rate)

Commentary of Fed’s Response

 The Fed and the 2001 Recession
Interest Rate MS1 MS2
In response to the events
surrounding the 2001
recession the Fed cut
interest rates by purchasing
r1
Treasury securities via open
market operations (lowering
the federal funds rate).
r2

Money Demand

M1 M2 Quantity of Money
 The Fed and the 2001 Recession
… Lower interest rates caused
LRAS
the aggregate demand curve to
P shift right. As a result, real
GDP and the aggregate price
level rose.

SRAS

P2

P1

AD2
AD1

Y1 Yp Real GDP
 Fiscal and Monetary Policy
During Periods of Stagflation
• Stagflation is characterized by a rising price level
(inflation), rising unemployment and falling
output.
• During periods of stagflation, monetary and fiscal
policy can be used to address only one of the
problems: either the fall in output or the rise in the
price level.
Monetary and Fiscal Policy with Stagflation
LRAS

SRAS2

SRAS1

P2
Stagflation is caused by a shift left
P1 in the SRAS curve. During
stagflation, monetary and fiscal
policy can not stabilize both output
and the price level.

AD1

Y2 Y1 Real GDP
 The Taylor Rule

• How does the Fed actually choose a target for the

federal funds rate?

• The Taylor Rule: A rule developed by John

Taylor that links the Fed’s target for the federal
funds rate to economic variables.
 The Taylor Rule

Federal funds target rate = Current inflation rate + Real

equilibrium federal funds rate + (1/2) x Inflation gap + (1/2) x
Output gap

Inflation Gap: Difference between current inflation and a target

level of inflation.
Output Gap: Difference between current real GDP and
potential real GDP.