Fiscal and Monetary Policy within the Keynesian Model
This piece fits in as an
addendum to the Keynesian theory topic.
Fiscal policy is the
conscious manipulation of government spending and/or taxes, with the purpose of
affecting equilibrium GDP. That is,
raising or lowering them to speed up or slow down the economy.
The impact of these changes
on the Keynesian cross is fairly simple.
To fight recession you take steps to raise aggregate expenditure and
boost equilibrium GDP. To fight
inflation (assumed here to be due to excessive aggregate expenditure) you do
the opposite.
Monetary policy is a little
harder to explain and understand. The
Fed will cut interest rates to stimulate the economy. Lower interest rates will normally cause
more investment spending to occur, as firms take advantage of low lending
rates. To control inflation interest
rates will be raised.
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On a more sophisticated
level, monetary policy can be understood as involving a chain of events which
the Fed sets off, which involves
1)increasing the money supply to lower interest rates, 2)which operates through
the investment demand curve to increase investment spending, 3)which in turn
causes an increase in aggregate expenditure, leading to higher equilibrium GDP.
These background theoretical
elements are involved:
The investment demand curve (marginal efficiency of
capital) shows the relationship between interest rates and investment
spending. The graph has rate of return
(on investment) or interest rate on the vertical axis, and quantity of
investment on the horizontal. A downsloping curve (or step function) rank orders the
investment options under considerations.
Each option involves some amount of money required to implement it, and
an expected rate of return. This graph
shows that the more money you plan to invest, the lower will be the rate of
return on the marginal project. A
hand-out graph shows a case in point, involving a hypothetical company. If we sum over all companies we get the
investment demand curve for the whole economy.
Given an actual interest rate, we can draw in a horizontal line at that
rate. Where it intersects the investment
demand curve, that is the amount of investment which
will be undertaken. All those projects
"above" the intersection are viable, those below are unfeasible.
The supply and demand for money graph shows how the
interest rate is actually determined, according to Keynes. The demand for money curve relates interest
rate (vertical axis) to the quantity of money demanded (horiz.). The curve is downsloping,
revealing that people will wish to have small money balances if the interest
rate is high (they would rather have less liquid assets such as bonds, to take
advantage of the high interest rates available). If the interest rate were to be lower, the
people would want large money balances (larger quantity of money
demanded). The fed sets the money supply
(a vertical supply curve) through its techniques of monetary policy, such a offering loans to banks via the discount rate, or
not. The intersection of money demand
and money supply determines the interest rate.
Since the fed controls the supply, it controls the interest rate. Incidentally, money demand may be affected by
other things than the interest rate. For
example if the economy is stronger (higher GDP), there will be greater demand
for money (rightward shift of the money demand curve) due to "transactions
demand" -- this is the need to have more money on hand if we are going to
make more purchases (like at Christmas time).
So, monetary policy to
stimulate the economy would work like this: Increase in the money supply brings
about lower equilibrium interest rate on the s&d
for money diagram. Next, the lower interest rate corresponds to a greater
quantity of investment spending on the investment demand curve. Lastly, the Agg. Expend. curve shifts
upward on the Keynesian cross diagram, raising equilibrium GDP.