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Birks – Mankiw 7th edn Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand

A commentary on Mankiw 7th Edn Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand (Mankiw 7th edition)

Mankiw, N. G. (2015) Principles of economics (7th ed.) Ch.34
Principles of macroeconomics
(7th ed.) Ch.21
Mason, OH: South-Western Cengage Learning

The Influence of Monetary and Fiscal Policy on Aggregate Demand

When reading the chapter, here are some aspects to consider:

1. Chapter 34 builds on Chapter 33 to introduce policy issues. Mankiw has chosen to use a model of aggregate demand and aggregate supply where aggregate demand is explained using his version of a “money market”. As you can see, for this exposition he is setting aside other influences such as wealth and exchange rate effects. As I described for Chapter 33, you should carefully note the assumptions being made for each model that you come across. The results are likely to depend on them, and they may change as you alter the assumptions. Mankiw may not always set them out clearly, but you should.

2. In relation to liquidity preference, you could consider the interest rate as the “price” of money (note the relationship between opportunity cost and price).

3. Note Mankiw’s assumption of constant expected rate of inflation (why is it useful?).

4. Note that the money market in this Chapter is not the same as the market for loanable funds in Chapter 26. It might be best to see them as quite distinct, and used for different parts of the course.

5. There are several possible monetary policy instruments, but Mankiw assumes here that the Fed has full control over the money supply using open market operations. Why does this result in a vertical supply curve? You have seen a vertical supply curve relating to NCO in section 2a of Chapter 32 – that is for a different market, but similar reasoning applies.

6. In section 1a in the discussion of equilibrium Mankiw refers to people buying interest-bearing bonds. You may find it helpful to think of people taking out a term deposit.

7. Figure 2 shows how the money market and aggregate demand interact, according to this model. Unlike the model described in Figure 4 of Chapter 32, there is no direct connection drawn between the two graphs. The vertical axes in the two graphs in Figure 2 are different. Bear this in mind, and make sure that you understand how the two graphs are interrelated. Take this a step further by considering the shifts in AD in Figure 3.

8. For Figure 3, remember that, if plans are realised, there is no incentive to change. However, if something elsewhere (some other determinant) changes, then plans may no longer be realised. Some people will then have an incentive to change their behaviour. At first we are on AD1. There is a change in money supply, resulting in a change in interest rate. This results in a change in demand for goods and services, and hence a shift in the AD curve to AD2. A change in the money market has altered one of the determinants of AD, giving a response there. Note also that AD is plotted against the price level. This means that a change in price level will result in a movement along the curve, whereas a change in any of the other determinants of AD will result in a shift of the curve.

9. Monetary policy can be specified in relation to interest rate or money supply. The Fed, or in NZ the Reserve Bank, can set one of these, after which the other is determined by the market. Given the various alternative measures of money supply, and, in New Zealand, structural changes in the financial sector which also affect these measures, the focus is often on interest rate rather than money supply.

10. For a given money supply, it is suggested that the AD curve is downward sloping. Consider:

  • Movements to the right (increased real income at a fixed price level) resulting in increased demand for money;
  • Movements down (decreased price level at a fixed real income) resulting in decreased demand for money.

There will therefore be a point down and to the right at which the increased demand from the rightward movement is balanced by the decreased demand from the downward movement. Hence the shape of the curve.

11. Now consider the effect of an increase in money supply. This could be used up through increased real income (a rightward movement in AD), or an increased price level (an upward movement in AD), or a combination of the two. Figure 3 explains the change in terms of the former, but either or both responses could be considered.

12. When considering fiscal policy, we should think of government spending, G, as spending on final goods and services. Spending on transfers, such as unemployment benefits, should be seen as “negative taxes”. They increase disposable income, whereas taxes reduce disposable income. That is why tax deductions for child care, for example, are considered as “tax expenditures”. They reduce taxable income and hence tax liability, and could instead be replaced with a “child care benefit” having the same effect.

13. Note that the investment accelerator can have a big impact on output. If demand is increasing, there is an incentive to increase capacity, with the cost of new capital perhaps being several times the value of a year’s output from the capital. If demand is falling, there is spare capacity and investment may fall to zero. In other words, investment can be very volatile in response to changes in demand. We see a similar phenomenon if we consider housing. If net inward migration is high, we need to increase the housing stock. If there is a net outflow, we may have an oversupply of housing.

14. Mankiw has chosen to present a model where fiscal policy changes directly affect aggregate demand and have an additional impact through the money market (with crowding out if the policy is expansionary). These are the only effects here because he has chosen to ignore any others. This illustrates the process of model building in economics. We can choose which elements to include and which to exclude. The models are not describing the real world, but hopefully they illustrate some phenomena which are important in the real world.

15. In relations to stabilisation, note the importance of available information and lags.

16. The description of automatic stabilisers is limited. If you have seen the extra material on the Keynesian Cross Model (Points 7 and 8 in this commentary on Chapter 26), you can consider automatic stabilisers in terms of the slope of the planned expenditure line, E. Imagine an economy at equilibrium. If income rises, without any change in E, then the economy moves into a disequilibrium position, with planned expenditure below realised expenditure (as indicated by the 45o line). This results in businesses having unplanned additions to inventory, and hence having an incentive to reduce output. Income falls back towards equilibrium. Now consider the effects of automatic stabilisers such as income taxes and unemployment benefits. Consider an economy, A, with no income tax and no unemployment benefits, and another economy, B, identical but for having both of these. For a given increase in income, B will experience a fall in unemployment benefits and an increase in income tax paid. Disposable income will therefore have risen by less than in A for a given initial increase in income. Consumption in B will therefore also have risen by less, and the excess production will be higher. This is reflected in a planned expenditure line which is flatter than in A. Producers in B have a greater incentive to reduce output, and so deviations from equilibrium may be smaller, and pressures to return to equilibrium greater. B will still have economic fluctuations, but they may be smaller than in A.

Note that automatic stabilisers can reduce fluctuations, but they are still fluctuating about the prevailing equilibrium. They do nothing to change that equilibrium.

Commentary by Stuart Birks, 5 September 2014

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