Economics

2. Macroeconomics

Part III - Monetary Policy and Fiscal Policy

2023/2024, P4
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Source:
https://www.ecb.europa.eu/ecb/e
ducational/explainers/tell-me-
more/html/interest_rates.en.html

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 Monetary Policy Influences AD

- The relationship between the Money Market and the slope of the
Aggregate-Demand Curve.

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 The Money Market (with a rigid supply of money) and
the Slope of the Aggregate-Demand Curve
(a) The Money Market (b) The Aggregate-Demand Curve
Interest Price
rate Money 2. . . . increases the level 1. An increase in the price level . . .
supply demand for money . . .
4. . . . which in turn
3. . . . which increases reduces the quantity
equilibrium interest rate . . . of goods and
r2 P2 services demanded.

r1 Money demand at
price level P2, MD2 P1

Money demand at Aggregate

price level P1, MD1 demand

0 Quantity fixed Quantity 0 Y2 Y1 Quantity

by the ECB of money of output

An increase in the price level from P1 to P2 shifts the money-demand curve to the right, as in panel (a). This
increase in money demand causes the interest rate to rise from r1 to r2. Because the interest rate is the cost of
borrowing, the increase in the interest rate reduces the quantity of goods and services demanded from Y1 to Y2.
This negative relationship between the price level and quantity demanded is represented with a downward-
sloping aggregate-demand curve, as in panel (b). 6
 The Money Market with perfectly elastic money supply
(unlimited supply of money)

The Money Market

Interest
rate With perfectly elastic money supply, an
increase in the demand for money . . .

. . . is accommodated with money supply in order

not to increase the equilibrium interest rate

Money demand at

money supply
Perfectly elastic
price level P2, MD2
r1

Money demand at
price level P1, MD1
0 Quantity
of money

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 Monetary Policy Influences AD

• When the aggregate demand curve shifts:

– the quantity of goods and services demanded changes
– for a given price level

• Monetary policy shifts the aggregate demand curve through

– Increase in money supply
– Decrease in money supply

• If the ECB increases the money supply (monetary injection)

– Money-supply curve shifts right
– Interest rate falls
– At any given price level
• Increase in quantity demanded of goods and services
– Aggregate-demand curve shifts right

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 A Monetary Injection
Interest (a) The Money Market Price (b) The Aggregate-Demand Curve
rate level
Money supply,
MS1 MS2
1. When the ECB
increases the
r1 money supply . . .
P

r2

AD2
Money demand Aggregate
at price level P demand, AD1
0 Quantity 0 Y1 Y2 Quantity of output
2. . . . the equilibrium of money 3. . . . which increases the quantity of goods
interest rate falls . . . and services demanded at a given price level.
In panel (a), an increase in the money supply from MS1 to MS2 reduces the equilibrium interest
rate from r1 to r2. Because the interest rate is the cost of borrowing, the fall in the interest rate
raises the quantity of goods and services demanded at a given price level from Y1 to Y2. Thus,
in panel (b), the aggregate-demand curve shifts to the right from AD1 to AD2. 9
 Monetary Policy Influences AD

• When the aggregate demand curve shifts:

– the quantity of goods and services demanded changes
– for a given price level

• Monetary policy shifts the aggregate demand curve through

– Increase in money supply
– Decrease in money supply

• If the ECB increases the money supply (monetary injection)

– Money-supply curve shifts right ECB actions:
– Interest rate falls - Change Interest rates
– At any given price level - Quantitative Easing (QE)
• Increase in quantity demanded of goods and services
– Aggregate-demand curve shifts right

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11
 ECB announces €750 billion Pandemic Emergency
Purchase Programme (PEPP)

18 March 2020

The Governing Council decided the following:

(1) To launch a new temporary asset purchase programme of private
and public sector securities to counter the serious risks to the
monetary policy transmission mechanism and the outlook for the euro
area posed by the outbreak and escalating diffusion of the
coronavirus, COVID-19.
This new Pandemic Emergency Purchase Programme (PEPP) will
have an overall envelope of €750 billion. Purchases will be conducted
until the end of 2020 and will include all the asset categories eligible
under the existing asset purchase programme (APP).

… 12
13
 The Governing Council takes its monetary policy
decision every six weeks. Immediately after the
meeting, the President and the Vice President of the
ECB explain the decision at the press conference
Press Conference, 11 March 2021

• “First, we will continue to conduct net asset purchases

under the pandemic emergency purchase programme
(PEPP) with a total envelope of €1,850 billion until at least the
end of March 2022 and, in any case, until the Governing Council
judges that the coronavirus crisis phase is over.”
• “Second, net purchases under our asset purchase programme
(APP) will continue at a monthly pace of €20 billion.”
• “Third, the Governing Council decided to keep the key ECB
interest rates unchanged.”
• “Finally, we will continue to provide ample liquidity through our
refinancing operations.”
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 Monetary policy decisions, 14 April 2022

Unchanged
since March 2016

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 Monetary policy decisions, May 2023

Consult the press release:

https://www.ecb.europa.eu/press/pr/date/2023/html/ecb.mp230504~cdfd11a697.en.html

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 Monetary policy decisions, May 2023

Consult the press release:

https://www.ecb.europa.eu/press/pr/date/2023/html/ecb.mp230504~cdfd11a697.en.html

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 Monetary policy decisions, May 2023

Consult the press release:

https://www.ecb.europa.eu/press/pr/date/2023/html/ecb.mp230504~cdfd11a697.en.html

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 Monetary policy decisions, April 2024

Consult the press release:

https://www.ecb.europa.eu/press/pr/date/2024/html/ecb.mp240411~1345644915.en.html

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 Monetary policy decisions, April 2024

Consult the press release:

https://www.ecb.europa.eu/press/pr/date/2024/html/ecb.mp240411~1345644915.en.html

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 Monetary policy decisions, April 2024

Consult the press release:

https://www.ecb.europa.eu/press/pr/date/2024/html/ecb.mp240411~1345644915.en.html

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 Monetary Policy Influences AD

• If the ECB decreases the money supply (liquidity absorption)

– Money-supply curve shifts left
– Interest rate increases
– At any given price level
• Decrease in quantity demanded of goods and services
– Aggregate-demand curve shifts left

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 Monetary Policy Influences AD

• If the ECB decreases the money supply (liquidity absorption)

– Money-supply curve shifts left
– Interest rate increases
– At any given price level
• Decrease in quantity demanded of goods and services
– Aggregate-demand curve shifts left

• Changes in monetary policy:

– Aimed at expanding aggregate demand
• Increasing the money supply
• Lowering the interest rate
– Aimed at contracting aggregate demand
• Decreasing the money supply
• Raising the interest rate

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 Transmission mechanism of monetary policy

More frequent price adjustments → More effectiveness of the

monetary policy transmission mechanism (why?)

See https://www.ecb.europa.eu/mopo/intro/transmission/html/index.en.html 24
 Fiscal Policy Influences AD

• Fiscal policy
– Government policymakers
– Set the level of government spending and taxation (budget)

• Shift the aggregate demand

– (1) Multiplier effect
– (2) Crowding-out effect

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 (1) Multiplier Effect

• The multiplier effect

– Additional shifts in Aggregate Demand
• Occur when expansionary fiscal policy increases income and
thereby increases consumer spending

• The multiplier effect of an increase in government purchases (G)

by €20 billion
– Aggregate-demand curve
• Shifts right by exactly €20 billion
– Consumers respond
• increases in aggregate income stimulate additional spending by
consumers
– Aggregate-demand curve
• Shifts right again

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 The Multiplier Effect
Price
level 2. . . . but the multiplier effect
can amplify the shift in
aggregate demand.
€20 billion

AD3
AD2
Aggregate demand, AD1

1. An increase in government purchases Quantity of

of €20 billion initially increases aggregate Output
demand by €20 billion . . .

An increase in government purchases of €20 billion can shift the aggregate-demand curve to the
right by more than €20 billion. This multiplier effect arises because increases in aggregate
income stimulate additional spending by consumers. 27
 Spending multiplier (MPC)

• Spending multiplier
– Marginal propensity to consume, MPC
• Fraction of extra income that consumers spend

– Size of the multiplier

• Depends on the MPC
• For instance, MPC<1 means that a change in income produced a
proportionally smaller change in consumption

– Thus, a larger MPC

• Larger multiplier & vice-versa.

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 Spending multiplier (MPC)
• Spending multiplier = 1/(1 – MPC)

• Because of multiplier effect

– €1 of government purchases
• Can generate > €1 of aggregate demand
– €1 of consumption, investment, or net exports
• Can generate > €1 of aggregate demand

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 Crowding-out Effect

• The crowding-out effect

– Offset in Aggregate Demand
– Results when expansionary fiscal policy raises the interest rate
– Thereby reduces investment spending

• The crowding-out effect of an increase in government spending (G)

– Aggregate Demand curve – shifts right
• Increase in income
• Money demand increases
• Interest rate increases
• Aggregate-Demand curve shifts left

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 The Crowding-Out Effect
(a) The Money Market (b) The Aggregate-Demand Curve
Interest
rate 2. . . . the increase in Price 1. When an increase in
Money
spending increases level government purchases
supply
money demand . . . increases aggregate demand…

3. . . . which increases the €20 billion

r2 equilibrium interest rate . . .

r1
MD2
AD2
AD3
Money demand, MD1 Aggregate demand, AD1
0 Quantity fixed Quantity 4. . . 0which in turn partly offsets the Quantity
by the ECB of money initial increase in aggregate demand. of output

Panel (a) shows the money market. When the government increases its purchases of goods and services, the resulting increase in
income raises the demand for money from MD1 to MD2, and this causes the equilibrium interest rate to rise from r1 to r2. Panel (b)
shows the effects on aggregate demand. The initial impact of the increase in government purchases shifts the aggregate-demand
curve from AD1 to AD2. Yet because the interest rate is the cost of borrowing, the increase in the interest rate tends to reduce the
quantity of goods and services demanded, particularly for investment goods. This crowding out of investment partially offsets the
impact of the fiscal expansion on aggregate demand. In the end, the aggregate-demand curve shifts only to AD3. 31
 Crowding-out effect with accommodative monetary
policy (unlimited supply of money)?

The Money Market When money supply is perfectly elastic,

Interest
rate the interest rate doesn’t change, and
the crowding-out effect doesn’t occur
- expansionary fiscal policy is more
effective!

money supply
Perfectly elastic
r1

0 Quantity
of money

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 Fiscal Policy Influences AD

• A decrease in personal income taxes

– Households’ income increases

– Multiplier effect
• Aggregate Demand increases
– Crowding-out effect (because money demand increases, so interest
rate increases and investment falls)
• Aggregate Demand decreases

– Permanent tax cut - large impact on AD

– Temporary tax cut - small impact on AD [because households will not
expand their consumption as they would under a permanent tax cut]

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 Fiscal Policy Influences AD

• A decrease in personal income taxes

– Households’ income increases

– Multiplier effect
• Aggregate Demand increases
– Crowding-out effect (because money demand increases, so interest
rate increases and investment falls)
• Aggregate Demand decreases

– Permanent tax cut - large impact on AD

– Temporary tax cut - small impact on AD [because households will not
expand their consumption as they would under a permanent tax cut]

What about a tax cut on citizens with lower incomes?

( - How is their PMC?)
( - As a result, the impact of the Fiscal Policy is higher or lower?)
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 The Effect of a Government Budget Deficit

• Government - starts with balanced budget

– Then starts running a budget deficit (government spends more than it
receives in tax revenue)
• Decrease in supply of loanable funds
– Supply curve shifts left
• New equilibrium
– Higher interest rate
– Smaller quantity of loanable funds

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 The Effect of a Government Budget Deficit
Interest S2
Rate Supply, S1

6% 1. A budget deficit
decreases the supply of
5%
loanable funds . . .
2. . . . which
raises the
Demand
equilibrium
interest rate
...
0 $800 $1,200 Loanable Funds
(in billions of dollars)
3. . . . and reduces the equilibrium quantity of loanable funds,
leaving less funds for private investment.

When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national
saving. The supply of loanable funds decreases, and the equilibrium interest rate rises. Thus, when the
government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow
to finance investment. Here, when the supply shifts from S1 to S2, the equilibrium interest rate rises from 5 to 6
percent, and the equilibrium quantity of loanable funds saved and invested falls from $1,200 billion to $800 billion.
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 The Effect of a Government Budget Deficit

• Government - budget deficit

– Interest rate rises
– Investment falls
• Crowding out
– Decrease in investment that results from government borrowing

• Government – budget surplus

– Increase supply of loanable funds
– Reduce interest rate
– Stimulates investment

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 Keynesians in the White House

• 1964, President John F. Kennedy

– Advocated a tax cut to stimulate the economy, known as Investment
tax credit
– John Maynard Keynes’s General Theory
– Stimulate aggregate demand
– Change incentives that people face
– Can alter the aggregate supply of goods
and services

• 1964, President John F. Kennedy

– Investment tax credit
• Tax break to firms that invest in new capital
• Higher investment
– Stimulate aggregate demand immediately
– Increase the economy’s productive capacity over time
– Enacted in 1964 38
• Period of robust economic growth
 Keynesians in the White House

• Fiscal policy
– Short-run: increase production through higher Aggregate Demand
– Long-run: increase production through higher Aggregate Supply

• 2009, President Barak Obama

– Economy in recession
– Policy: stimulus bill
• Substantial increase in government spending (G)
• The American Recovery and Reinvestment Act of 2009

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 Using Policy for Stabilization Purposes

• The case for active stabilization policy

– A change in Aggregate-Demand
• The government uses fiscal policy
• The ECB uses monetary policy
• To stabilize the economy

• Keynes
– Key role of AD in explaining short-run economic fluctuations
– The government should actively stimulate Aggregate Demand
• When AD appeared insufficient to maintain production at its full-
employment level

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 Using Policy for Stabilization Purposes

• Case against active stabilization policy

– Government
• Should avoid active use of monetary and fiscal policy to try to
stabilize the economy
• Because they affect the economy with a big lag

– Policy instruments
• Should be set to achieve long-run goals
• The economy should be left alone to deal with short-run
fluctuations

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42
 Using Policy for Stabilization Purposes

• Automatic stabilizers
– Changes in fiscal policy
• That stimulate Aggregate Demand when the economy goes into
a recession without policymakers having to take any
deliberate action from:
• The tax system
• Government spending

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 Using Policy for Stabilization Purposes

• Automatic stabilizers – Taxes & Unemployment Benefits

– Changes in fiscal policy
• That stimulate Aggregate Demand when the economy goes into
a recession without policymakers having to take any
deliberate action from:
• The tax system
• Government spending

Not sufficiently strong to prevent recessions completely.

– Without them output and employment would probably be more
volatile than they are.

• In a recession
– Taxes fall, government spending rises
• Government’s budget moves toward deficit

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 The Laffer curve

• Relationship between tax rates and the resulting government

revenue.
• Increasing tax rates beyond a certain level (prohibitive range of the
Laffer curve) is counter-productive for raising tax revenue, because
– some economic activities are no longer worth (too high opportunity
cost)
– tax evasion

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 The Laffer curve

• Laffer curves are different among countries, which may raise a

discussion about fiscal discipline and harmonization in the
Eurozone.
• In recession times the Laffer curve tends to move to the left,
reducing the optimal tax rate. Hence, if tax rates are not revised
downwards, the country risks entering the prohibitive zone.

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 Readings

Mankiw and Taylor, Ch. 27, Ch. 28, Ch. 34.

https://www.imf.org/en/Publications/fandd/issues/2023/03/rethinking-
monetary-policy-in-a-changing-world-brunnermeier

Food for thought:

The cases for and against central banks responding to environmental

and sustainability challenges:
https://www.bruegel.org/blog-post/green-central-banking

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