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4 Demandside and Supplyside Policies
Money, banking, and financial markets (AP only) Blog posts: "Multiplier effect"
• Measures of money supply
• Banks and creation of money
• Money demand
• Money market
• Loanable funds market
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Reduction in corporate taxes: increases incentive to invest in new capital. An increase in the nation's
capital stock increases potential output of the economy
Reduction in trade union power: Unions fight for higher wages, which increases firms' costs. Lower
wages will lower costs to firms and increase their ability to produce more output
Reduction or elimination of minimum wages: Lower minimum wage will lower firms' costs, increasing
their potential output and aggregate supply
Reduction in unemployment benefits: Generous benefits for the unemployed reduce the incentive to
find work, reducing the supply of available labor. Fewer benefits increase supply of labor and AS
Deregulation: Burdensome regulations of business can increase costs for firms. Deregulating business
operations will lower firms' costs and increase AS
Privatization: Transferring state-run firms to the private sector may lead to greater efficiency as
firms compete to minimize costs and maximize profits
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Example: the 2009 American Recovery and Reinvestment Act is a $784 spending and tax cut
package aimed at getting the US out of recession:
"In the face of an economic crisis, the magnitude of which we have not seen since the Great
Depression, the American Recovery and Reinvestment Act represents a strategic -- and
significant -- investment in our country’s future.
The Act will create or save three to four million jobs, 90 percent of them in the private
sector. It will provide more than $150 billion to low-income and vulnerable households --
spurring increased economic activity that will save or create more than one million jobs.
These measures are necessary to help the millions of families whose lives have been upended
by the economic crisis. But, this Act will do more than provide short-term stimulus. By
modernizing our health care, improving our schools, modernizing our infrastructure, and
investing in the clean energy technologies of the future, the Act will lay the foundation for a
robust and sustainable 21st century economy."
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
The ARRA: How will each of the components of the ARRA lead to an increase in
Aggregate Demand, a decrease in unemployment and an increase in GDP in
America?
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
The ARRA: How will each of the components of the ARRA lead to an increase in Aggregate
Demand, a decrease in unemployment and an increase in GDP in America? What are the
potential supply-side effects of the program?
State and local fiscal relief Infrastructure and Science Tax Relief
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
• Some economists tend to favor higher G during recessions and higher taxes during
inflationary times if they are concerned about unmet social needs or infrastructure.
• Others tend to favor lower T for recessions and lower G during inflationary periods when
they think government is too large and inefficient.
Scenario: Government wants to boost output by 200 billion dollars. Assume the
nation's MPC = .55. What should the government do, cut taxes or increase
government spending?
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Rationale: 45% of any tax cut will go towards savings, purchase of imports or debt repayment, all
of which are leakages from the circular flow. Only 55% will turn into new spending in the economy
Rationale: An increase in government spending represents a direct injection into the economy, as
none of it will be leaked in the form of savings, purchase of imports or debt repayment
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Automatic stabilizers in Fiscal Policy: Built-in stability arises because net taxes (taxes
minus transfers and subsidies) change with GDP. It is desirable for spending to rise when
the economy is slumping and vice versa when the economy is becoming inflationary.
G and T (billions $)
with GDP because incomes fall.
The more progressive the tax system, the greater the economy’s built-in
stability.
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Money comes in many forms: A nation's money supply is larger than just the amount
of paper money in circulation. It also includes less liquid forms of money.
M1= currency and checkable deposits: Currency (coins + paper money) held
Most liquid
by public.
• Is “token” money, which means its intrinsic value is less than actual value. The
metal in a dime is worth less than 10¢.
• All paper currency consists of Federal Reserve Notes issued by the Federal
Reserve.
• Checkable deposits are included in M1, since they can be spent almost as
readily as currency and can easily be changed into currency.
Qualification: Currency and checkable deposits held by the federal government,
Central Bank, or other financial institutions are not included in M1.
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Dm
Total demand for money Qm
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
The US Federal Reserve System: Who's in charge of monetary policy in the US?
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
• Control: Required reserves do not exist to protect against “runs,” because banks must keep
their required reserves. Required reserves are to give the Federal Reserve control over the
amount of lending or deposits that banks can create. In other words, required reserves help the
Fed control credit and money creation.
• Asset and liability: Reserves are an asset to banks but a liability to the Federal Reserve Bank
system, since now they are deposit claims by banks at the Fed.
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
• Money supply can increase: If a central bank wishes to lower interest rates, it
can increase the supply of money in the economy by buying bonds from the public
• Money supply can decrease: If a central bank wishes to increase interest rates, it
can decrease the supply of money in the economy by selling bonds to the public
Expansionary Monetary Policy Contractoinary Monetary Policy
S S1 S1 S
Interest rate
Interest rate
6%
5% 5%
4%
Dmoney Dmoney
Q1 Q2 Q2 Q1
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
The higher price of bonds on the market causes the interest rates on bonds to decrease, households
and firms want to exchange their bonds for money. The central bank takes cash from its vaults (not
part of the money supply) and buys bonds from the public. Checkable deposits and excess reserves
increase, money supply increases, interest rate in the economy falls.
P Bond Market
Expansionary Monetary for $100 T-bills
Policy - to lower interest Sb
rates, CB buys bonds on the
bond price: $97
open market interest rate: 3%
97
94
Db
Q Q1 Qb
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Db
Q Q1 Qb
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Interest rate
P1
5% Pe
4% AD2(after multiplier)
ADΔI
AD
Dmoney DI
Q1 Q2 Q1 Q2 Ye Yfe
Quantity of money Quantity of Investment real GDP
Money Market
w/Contractoinary Monetary Policy Investment Demand PL LRAS
SRAS
S1 S
Interest rate
Interest rate
Pe
6% P1
AD
5% ADΔI
AD2(after
multiplier)
Dmoney DI
Q2 Q
1
Q2 Q1 YfeYe
Quantity of money Quantity of Investment real GDP
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Expansionary Monetary Policy and the Federal Funds rate: How the Fed's OMOs lead to lower
commercial interest rates
• When banks’ reserves increase, the supply of “federal funds” shifts down, lowering the
interest rates that banks charge one another for overnight loans. Federal funds are the cash
that banks often loan to one another at the end of each day in order to meet their reserve
requirements.
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Expansionary Monetary Policy and the Federal Funds rate: How the Fed's OMOs lead to lower
commercial interest rates
The Federal Funds rate and monetary policy, an example:
• Assume Bank A has finds at the end of the day that it has received more deposits than
withdrawals, and it now has $1m more in its reserves than it is required to have. Bank A wants
to lend that money out as soon as possible to earn interest on it.
• Bank B, on the other hand, received more withdrawals than it did deposits during the day, and
is $1m short of its required reserves at day’s end. Bank B can borrow Bank A’s excess reserves in
order to meet its reserve requirement.
• Bank A will not lend it for free, however, and the rate it charges is called the “federal funds”
rate, since banks’ reserves are held predominantly by their district’s Federal Reserve Bank.
• Funds at the regional Federal Reserve Bank ("federal funds") will be transferred from Bank A's
account to Bank B's account. Both banks have now met their reserve requirements, and Bank A
earns interest on its short-term loan to Bank B.
When the Fed buys bonds, all banks experience an increase in their reserves, meaning the
supply of federal funds shifts out (or down in the graph above), lowering the interest rate on
federal funds. Lower interest rates on overnight loans will encourage banks to be more
generous in their lending activity, allowing them to lower the prime interest rate (the rate they
charge their most credit-worthy borrowers), which in turn should have a downward effect on all
other interest rates.
Blog post: "Helicopter Ben and Monetary Policy: the cartoon version!"
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Central Bank
Central Bank buys Central Bank buys
bonds from public, bonds from banks,
increasing amount of injecting liquidity to
checkable deposits excess reserves
$
$ $
$
$ $ B
B
B
$ B
$
B
B B $ B
$ $ $ $
the Public Commercial
Banks
Contractionary Monetary Policy - how it works:
checkable Excess
CB sells bonds Interest GDP,
deposits and reserves, FF Rate C, I AD employment,
to public and rates
bank reserves money price level
banks
supply
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Quick Quiz:
For each of the following, draw an AD/AS diagram showing the effect on
America's national output, price level and employment. Then identify an open
market operation the Federal Reserve Bank can engage in to try and correct
each of the problems described.
Use the following diagrams to illustrate the effect of the Fed's open market
operations.
• Bond market
• Money market
• AD/AS diagram
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
The Reserve Ratio (AP only): another “tool” a Central Bank can use to influence the
money supply
• It is the fraction of total deposits that banks are required to keep on reserve.
• In the Unites States commercial banks deposit their required reserves to their
regional Federal Reserve Bank. Commercial banks only keep a tiny fraction of their
total required reserves in their own vaults on any given day
Excess reserves: The amount of a bank's reserves beyond those required by the
government or central bank. Excess reserves may be lent out to earn interest for the
bank
Raising the reserve ratio increases required reserves and shrinks excess reserves.
Any loss of excess reserves shrinks banks’ lending ability and, therefore, the
potential money supply by a multiple amount of the change in excess reserves.
Lowering the reserve ratio decreases the required reserves and expands excess
reserves. Gain in excess reserves increases banks’ lending ability and, therefore, the
potential money supply by a multiple amount of the increase in excess reserves.
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
The Money Multiplier: The money multiplier tells us the maximum amount of new
money that can be created by a single initial dollar of excess reserves. This
multiplier, m, is the inverse of the reserve requirement, R: m = 1/R
The US Federal Reserve Bank requires commercial banks to keep 10% of their total
deposits in reserve.
If the change in bank deposits is from money already in the money supply (i.e. a
worker deposits a paycheck or you deposit a birthday check from your grandparents),
then we must subtract the original amount from total change in the money supply
Example: Jonny deposits a $1000 check from his grandpa in the bank. How
much new money is created because of his wise decision to save his money?
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
The Reserve Ratio as a tool of Monetary Policy: Changing the reserve ratio
is a powerful way to stimulate or reduce total spending in the economy
For example: Assume the US Fed wishes to restrict the total amount of money in
circulation to increase the interest rate and reduce C and I. By raising the reserve
ratio, it can achieve a smaller money supply and a higher interest rate.
With fewer excess reserves to lend out, the supply of loanable funds decreases and the
interest rate rises. When new deposits are made, the banks must keep a larger
proportion in reserve, reducing the overall money supply in the economy
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
The Discount Rate - the third Monetary Policy available to a Central Bank:
The discount rate is the interest rate that the Central Bank charges to commercial
banks that borrow from the Central Bank
• The Central Bank (the Fed in the US) is "lender of last resort" to commercial banks
that have immediate needs for additional funds (i.e. if at the end of a business day a
bank does not have enough in its reserves to meet its reserve requirements, it must
borrow from other banks or from the Fed to fulfill this reserve requirement)
• Commercial banks can temporarily increase their reserves by borrowing from the
Fed.
• An increase in the discount rate signals that borrowing reserves is more difficult
and will tend to shrink excess reserves.
• A decrease in the discount rate signals that borrowing reserves will be easier and
will tend to expand excess reserves.
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Reserve ratio: The RR is RARELY changed. RR in the US has been .10 since 1992. Reserves
held by the Central Bank earn no interest, so if RR is raised, banks' profits suffer
dramatically since they have to deposit more of their total reserves with the Fed where
they earn no interest. Banks prefer to be able to lend out as much of their total reserves
as possible
Discount rate: Until recently, the discount rate in the US was rarely adjusted on its own,
and instead hovered slightly above the federal funds rate*. In 2008, the US Fed lowered
the discount rate to very low levels as uncertainty among commercial banks brought
private lending to a halt. The "discount window" is only supposed to be used in the case of
private lenders being unable to acquire funds, hence the Fed is the lender of last resort
Question: How do governments get money to finance their budgets if they lower
taxes at the same time that they increase spending (expansionary fiscal policy)?
Answer: they borrow from the public by issuing new government bonds
BOND (definition): The general term for a long-term loan in which a borrower agrees to pay
a lender an interest rate (usually fixed) over the length of the loan and then repay the
principal at the date of maturity. Bond maturities are usually 10 years or more, with 30 years
quite common. Bonds are used by corporations and federal, state, and local governments to
raise funds. (source: www.amosweb.com/)
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Money Market
Investment Demand
S S1
Interpretation: The
government's "transaction
Interest rate
Interest rate
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
The Loanable Funds Market (AP only): the loanable funds market is a hypothetical
market that brings savers and borrowers together, also bringing together the money available in
commercial banks and lending institutions available for firms and households to finance
expenditures, either investments or consumption (source: Wikipedia)
• Savers supply the loanable funds; for instance
• In return, borrowers demand loanable funds
DLF
Qe
Blog PostQuantity
- "Loanable Funds
of Loanable vs. Money Market: what’s the difference?"
Funds
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Interest rate
6%
5%
Private investment is
"crowded-out" due to
increased government
borrowing
DLF DI
Qe Qe Q2 Q1
Quantity of Loanable Funds Quantity of Investment
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Follow the link above for a great practice activity with fiscal and monetary
policies and their effect on AD/AS. The following is from the ThinkEconomics site:
To achieve the economic goals of low unemployment and stable prices, the Congress and the
President can use two fiscal policy instruments, government spending and taxation to affect
real GDP and the price level. In addition, the Federal Reserve can use three monetary policy
instruments, open market operations and changes in the discount rate and required reserve
ratio to change real GDP and the price level.
A Federal Reserve (Fed) open market purchase of U.S. securities, a decrease in the discount
rate or a decrease in the required reserve ratio increase the money supply, thereby increasing
aggregate demand and the equilibrium level of real GDP, Q*, and the equilibrium price level,
P*. Alternatively, a Fed open market sale of U.S. securities, an increase in the discount rate or
an increase in the required reserve ratio decrease the money supply, thereby decreasing
aggregate demand and the equilibrium level of real GDP, Q*, and the equilibrium price level,
P*.
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
• Government announces a large increase in spending on health and education.
Impact on AD Impact on AS
• Washington announces tax exemption scheme on new investments for small to medium sized businesses.
Impact on AD Impact on AS
• Average wage rises way above inflation for the third month running.
Impact on AD Impact on AS
• Exchange rate appreciation knocks export hopes for manufacturing.
Impact on AD Impact on AS
• Share prices tumble, wiping 20% off company values.
Impact on AD Impact on AS
• Surveys show clear signs of optimism for the future of the economy.
Impact on AD Impact on AS
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
• American productivity levels at their highest level for 10 years.
Impact on AD Impact on AS
• Government 'stealth taxes' increase tax burden to highest level for 50 years.
Impact on AD Impact on AS
• Expansion in numbers of students attending higher education exceeds government targets.
Impact on AD Impact on AS
• Federal Reserve signals rise in interest rates of ½%.
Impact on AD Impact on AS
• No rate rise in US but UK and EU central banks increase interest rates.
Impact on AD Impact on AS
• Radical reform of welfare spending should help government cut spending as a proportion of GDP.
Impact on AD Impact on AS
• Stability of inflation cheers business leaders.
Impact on AD Impact on AS
• United States leads the way in nanotechnology development
Impact on AD Impact on AS
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IB /AP Economics Unit 3.4 Demandside and Supplyside Policies
Group A: Group C:
• Problem: sharp rise in oil prices • Problem: Increased demand from abroad for
• Keynesian response exports fuels domestic inflation
• Keynesian response
• Classical response
• Classical response
Group B: Group D:
• Problem: Stock market bubble bursts • Proble: Embargo placed on country's exports
• Keynesian response • Keynesian response
• Classical response • Classical response
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