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which banks charge each other on shortterm loans  To change the interest rate and shift the AD curve, the Fed conducts open market operations to change the money supply. 21 CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY The Effects of Reducing the Money Supply Y P M Interest rate AD1 MS1 MD P1 Y1 r1 MS2 r2 AD2 Y2 The Fed can raise r by reducing the money supply. An increase in r reduces the quantity of gamp。 s demanded. A C T I V E L E A R N I N G 2: Exercise For each of the events below, determine the shortrun effects on output determine how the Fed should adjust the money supply and interest rates to stabilize output A. Congress tries to balance the budget by cutting govt spending. B. A stock market boom increases household wealth. C. War breaks out in the Middle East, causing oil prices to soar. 22 A C T I V E L E A R N I N G 2: Answers A. Congress tries to balance the budget by cutting govt spending. This event would reduce agg demand and output. To offset this event, the Fed should increase MS and reduce r to increase agg demand. 23 A C T I V E L E A R N I N G 2: Answers B. A stock market boom increases household wealth. This event would increase agg demand, raising output above its natural rate. To offset this event, the Fed should reduce MS and increase r to reduce agg demand. 24 A C T I V E L E A R N I N G 2: Answers C. War breaks out in the Middle East, causing oil prices to soar. This event would reduce agg supply, causing output to fall. To offset this event, the Fed should increase MS and reduce r to increase agg demand. 25 26 CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY Fiscal Policy and Aggregate Demand  Fiscal policy: the setting of the level of govt spending and taxation by govt policymakers  Expansionary fiscal policy • an increase in G and/or decrease in T • shifts AD right  Contractionary fiscal policy • a decrease in G and/or increase in T • shifts AD left  Fiscal policy has two effects on AD. 27 CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY The Multiplier Effect  If the govt buys $20b of planes from Boeing, Boeing’s revenue increases by $20b.  This is distributed to Boeing’s workers (as wages) and owners (as profits or stock dividends).  These people are also consumers, and will spend a portion of the extra ine.  This extra consumption causes further increases in aggregate demand. Multiplier effect: the additional shifts in AD that result when fiscal policy increases ine and thereby increases consumer spending 28 CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY The Multiplier Effect A $20b increase in G initially shifts AD to the right by $20b. The increase in Y causes C to rise, which shifts AD further to the right. Y P AD1 P1 AD2 AD3 Y1 Y3 Y2 $20 billion 29 CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY Marginal Propensity to Consume  How big is the multiplier effect? It depends on how much consumers respond to increases in ine.  Marginal propensity to consume (MPC): the fraction of extra ine that households consume rather than save  ., if MPC = and ine rises $100, C rises $80. 30 CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY Notation: G is the change in G, Y and C are the ultimate changes in Y and C Y = C + I + G + NX identity Y = C + G I and NX do not change Y = MPC Y + G because C = MPC Y solved for Y 1 1 – MPC Y = G A Formula for the Multiplier The multiplier 31 CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY The size of the multiplier depends on MPC. ., if MPC = multiplier = 2 if MPC = multiplier = 4 if MPC = multiplier = 10 1 1 – MPC Y = G A Formula for the Multiplier The multiplier A bigger MPC means changes in Y cause bigger changes in C, which in turn cause more changes in Y. 32 CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY Other Applications of the Multiplier Effect  The multipl。