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Economics: Monetary Policy: Accommodation

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About this Lesson

  • Type: Video Tutorial
  • Length: 9:41
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 104 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Monetary and Fiscal Policy (17 lessons, $27.72)
Economics: Monetary Policy: The Mainstream (5 lessons, $8.91)

This video lesson on economics looks at accommodation as a Monetary Policy. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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Thinkwell
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We've seen before how fiscal policy leads to crowding out, that is when the government spends more increasing income and increasing prices, the government increases the demand for money which pushes up the interest rate and crowds out business spending. Consider the following question. Can the Fed do anything to prevent crowding out or mitigate its affects? That is, can appropriate monetary policy accommodate government spending? That is, make it possible for the government to spend more increasing output without driving up interest rates and pushing out businesses. How might that happen? Let's consider the following story and I'm going to tell this story here on my storyboard instead of going directly to the graph because interest rates are not represented in the graph. Remember a movement along the aggregate demand curve is a change in the interest rate, as prices rise, the demand for money increases and the interest rate is driven up in the money market. So any time you move up along the aggregate demand curve, the interest rate is rising. That's why output is falling because businesses are buying less. But since the interest rate isn't clearly shown in that diagram, I want to start with this story before we look at the picture.
Here's the way the story works. The government spends more money. The government buys more stuff. That increases equilibrium gross domestic product and at the same time pushes up the price level. The consequence of these two changes is an increase in the demand for money. An increase in the demand for money is an outward shift in the red curve in the money market because the money supply is fixed by the Fed; the consequence then is a higher interest rate to give us equilibrium in the money market. That higher interest rate, however, crowds out business spending by making it more expensive to finance the purchases of plants and equipment and other investment goods. So that's how crowding out usually works. The Fed, however, can respond to the increased money demand by making more money available. If the Fed increases the money supply, the Fed can prevent the increase in interest rates. If we slap on extra money supply at this point in the story, everything changes. The money supply curve shifts out from its original level to this new level. And with this new level, money supply is such that the new money demand is met at the original interest rate. So if the Fed is willing to provide the money that the market wants at the original interest rate by increasing the money supply, there's no affect on interest rates, and therefore, no affect on investment spending, no crowding out. This is what we mean by accommodating money policy. If the Fed increases the money supply in an act of accommodation, what they are doing is preventing the interest rate from rising so that investment is not crowded out. Now let's see how that works in our model.
Suppose now that the government increases spending. If the government increases spending, then what's going to happen is an increase in income and an increase in the price level? Two things are going to happen. First of all, the increase in income alone at the original price level increases money demand. Even if the price level stays at its original equilibrium level, there's going to be an increase in demand for money because people need more money to do the extra shopping that's implied by this higher level of gross domestic product. So as people scramble to get that money, they're bidding up the interest rate and, therefore, investment spending is going to be crowded out. That's why this horizontal distance here, the increase in aggregate demand is going to be less than if the government were spending without a change in the interest rate. So to some extent the outward shift of the aggregate demand curve is already mitigated by crowding out, that is the aggregate demand curve's outward shift from government spending is constrained or pulled in a little bit because businesses are crowded out by the rising interest rates. Now when prices start to rise, that affect is compounded. When prices begin to rise, then demand for money increases further because people need more cash to do shopping when the price tags are bigger. The increased demand in money pushes interest rates up further and further crowds out business spending. That's why we end up with an output level, Y1, in the short-run equilibrium that's less than we would get if we were over here and prices hadn't increased.
Now what can the Fed do to prevent this crowding out? Well, what the Fed could do is increase the money supply and if the Fed increased the money supply, then we wouldn't get this affect over here from crowding out. There would be no constraint and the aggregate demand curve would actually shift out even further, out to some level like this. We'll call this AD2, where aggregate demand's 2 is the effect not only of increased government spending, but the additional effect of Fed accommodation. By increasing the money supply as we saw in our storyboard a moment ago, the Fed prevents interest rates from rising and keeps business spending from being crowded out. Now, of course, there's going to be an affect of increased prices because of the excess demand, so in the short run, prices are going to go up so the Fed has to really jolt the economy with extra money to provide not only enough extra money to meet the increased amount of shopping that people are doing at these large gross domestic product levels, but the Fed also has to give you enough money to compensate for these higher prices that are inevitable in the short run. So that's how accommodation works. The Fed does what it takes to increase money supply to meet money demand so that interest rates remain unchanged and business spending is not crowded out.
Now what's going to happen in the long run? Well, look what's going to happen in the long run. Let's go ahead and look right at the long run equilibrium where the red curve touches the green curve. The more the Fed accommodates, the more the Fed pumps money in, the higher the long-run price level gets, that is the blue curve before long starts to shift upwards simply because we're above full employment, that means pressure on the wages, pressure on input prices and eventually those get passed on to customers as businesses raise their prices. But how far up does the blue curve have to shift before we get to a new equilibrium? If the Fed does not accommodate and let's the government spend and let's the natural course of price adjustment bring us back to full employment on the green curve, then we would be stopping at a point like this one. If, however, the Fed has jolted it to the economy and tried to keep interest rates from rising, then we're going to get a lot more price adjustment, the price level is going to go up a lot higher as the short-run aggregate supply curve has further to travel to bring us back to the green curve. Now you're saying, whoa, hold on. As prices start to rise, doesn't the Fed have to keep increasing the money supply to keep interest rates from rising? Now you see the problem. Fed accommodation is a short-run strategy. You can only accommodate in the short run. Once prices start rising, the Fed's hooked. If they want to keep interest rates down, they have to keep pumping money into the system and if they do, that's going to set up even more inflation once adjustment occurs and we head towards the long run. So Fed accommodation is a short-run strategy. If the government has a temporary increase in spending, the Fed might accommodate to keep interest rates from rising. But if this long run, if this increase in government spending is a permanent change in the government`s behavior, then the Fed can't really accommodate in the long run. All it does is set up more inflation.
Here's the problem. The Fed cannot keep the economy permanently above full employment output. The longer the Fed tries to hold us at an output level like Y1 or higher, the longer the Fed tries to hold the economy beyond its speed limit, the more inflation the Fed is setting up for the long run. Now, once again, the ability of the Fed to accommodate even in the short run is constrained by people's expectations. If people see what the Fed is doing and see that this inflation is coming, everybody's going to raise their prices now so that they're not caught behind the stampede. If people anticipate the inflation and raise their prices now, workers demanding higher wages, businesses trying to pass on increases and input prices right now, if they do that, then we go immediately to the new long-run level. If people's expectations are rational, the Fed cannot accommodate even in the short run because people see that the consequence of this new increase in the money supply is going to be higher prices and people go there directly.
So Fed accommodation means that when the government spends more money, the Fed makes available money supply to match the increased money demand, however, any time the Fed tries to hold output above full employment, it sets up inflation. How soon will that inflation occur? It just depends on how forward looking people are. The more rational the expectations, the quicker prices are going to adjust and the less effective the increased money supply will be in accommodating the increased government spending.
Monetary and Fiscal Policy
Monetary Policy: The Mainstream
Monetary Policy: Accommodation Page [2 of 2]

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