06.09.

2011

Aggregate Demand

The Influence of
Monetary and Fiscal
Policy on Aggregate
Demand

34

Many factors influence aggregate demand

besides monetary and fiscal policy.
In particular, desired spending by households
and business firms determines the overall
demand for goods and services.

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Copyright 2004 South-Western

HOW MONETARY POLICY

INFLUENCES AGGREGATE DEMAND

Aggregate Demand
When desired spending changes, aggregate
demand shifts, causing short-run fluctuations in
output and employment.
Monetary and fiscal policy are sometimes used
to offset those shifts and stabilize the economy.

The aggregate demand curve slopes downward

for three reasons:
The wealth effect
The interest-rate effect
The exchange-rate effect

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HOW MONETARY POLICY

INFLUENCES AGGREGATE DEMAND
For the U.S. economy, the most important
reason for the downward slope of the
aggregate-demand curve is the interest-rate
effect.

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The Theory of Liquidity Preference

Keynes developed the theory of liquidity
preference in order to explain what factors
determine the economys interest rate.
According to the theory, the interest rate adjusts
to balance the supply and demand for money.

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06.09.2011

The Theory of Liquidity Preference

The Theory of Liquidity Preference

Money Supply

Money Demand

The money supply is controlled by the Fed through:

Open-market operations
Changing the reserve requirements
Changing the discount rate

Because it is fixed by the Fed, the quantity of

money supplied does not depend on the interest
rate.
The fixed money supply is represented by a vertical
supply curve.

Money demand is determined by several factors.

According to the theory of liquidity preference, one of
the most important factors is the interest rate.
People choose to hold money instead of other assets that
offer higher rates of return because money can be used to
buy goods and services.
The opportunity cost of holding money is the interest that
could be earned on interest-earning assets.
An increase in the interest rate raises the opportunity cost
of holding money.
As a result, the quantity of money demanded is reduced.

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Copyright 2004 South-Western

The Theory of Liquidity Preference

The Theory of Liquidity Preference

Equilibrium in the Money Market

Equilibrium in the Money Market

According to the theory of liquidity preference:

The interest rate adjusts to balance the supply and
demand for money.
There is one interest rate, called the equilibrium interest
rate, at which the quantity of money demanded equals the
quantity of money supplied.

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Figure 1 Equilibrium in the Money Market

Money
supply

r1
Equilibrium
interest
rate

Money
demand
Md

Quantity fixed
by the Fed

M2d

The price level is stuck at some level.

For any given price level, the interest rate adjusts to
balance the supply and demand for money.
The level of output responds to the aggregate demand for
goods and services.

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The Downward Slope of the Aggregate

Demand Curve

Interest
Rate

r2

Assume the following about the economy:

The price level is one determinant of the

quantity of money demanded.
A higher price level increases the quantity of
money demanded for any given interest rate.
Higher money demand leads to a higher interest
rate.
The quantity of goods and services demanded
falls.

Quantity of
Money
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06.09.2011

The Downward Slope of the Aggregate

Demand Curve
The end result of this analysis is a negative
relationship between the price level and the
quantity of goods and services demanded.

Figure 2 The Money Market and the Slope of the

Aggregate-Demand Curve

(a) The Money Market

Interest
Rate

(b) The Aggregate-Demand Curve

Price
Level

Money
supply
2. . . . increases the
demand for money . . .

P2

r2
Money demand at
price level P2 , MD2
r

3. . . .
which
increases
the
equilibrium 0
interest
rate . . .

Money demand at
price level P , MD
Quantity
of Money

Quantity fixed
by the Fed

1. An
P
increase
in the
price
level . . . 0

Aggregate
demand
Y2

Quantity
of Output
4. . . . which in turn reduces the quantity
of goods and services demanded.

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Figure 3 A Monetary Injection

Changes in the Money Supply

The Fed can shift the aggregate demand curve
when it changes monetary policy.
An increase in the money supply shifts the
money supply curve to the right.
Without a change in the money demand curve,
the interest rate falls.
Falling interest rates increase the quantity of
goods and services demanded.

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(b) The Aggregate-Demand Curve

(a) The Money Market

Interest
Rate

2. . . . the
equilibrium
interest rate
falls . . .

Money
supply,
MS

Price
Level

MS2

1. When the Fed

1
increases the
money supply . . .

r2

AD2
Money demand
at price level P

Quantity
of Money

Aggregate
demand, AD
0

Quantity
of Output

3. . . . which increases the quantity of goods

and services demanded at a given price level.

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Changes in the Money Supply

The Role of Interest-Rate Targets in Fed

Policy

When the Fed increases the money supply, it

lowers the interest rate and increases the
quantity of goods and services demanded at any
ggiven pprice level, shifting
g aggregate-demand
gg g
to
the right.
When the Fed contracts the money supply, it
raises the interest rate and reduces the quantity
of goods and services demanded at any given
price level, shifting aggregate-demand to the
left.

Monetary policy can be described either in

terms of the money supply or in terms of the
interest rate.
Changes in monetary policy can be viewed
either in terms of a changing target for the
interest rate or in terms of a change in the
money supply.
A target for the federal funds rate affects the
money market equilibrium, which influences
aggregate demand.

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06.09.2011

HOW FISCAL POLICY INFLUENCES

AGGREGATE DEMAND
Fiscal policy refers to the governments choices
regarding the overall level of government
purchases or taxes.
Fiscal policy influences saving, investment, and
growth in the long run.
In the short run, fiscal policy primarily affects
the aggregate demand.

Changes in Government Purchases

When policymakers change the money supply
or taxes, the effect on aggregate demand is
indirectthrough the spending decisions of
firms or households.
When the government alters its own purchases
of goods or services, it shifts the aggregatedemand curve directly.

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Changes in Government Purchases

The Multiplier Effect

There are two macroeconomic effects from the

change in government purchases:

Government purchases are said to have a

multiplier effect on aggregate demand.

The multiplier effect

The crowding-out
g
effect

Each dollar spent by the government can raise the

aggregate demand for goods and services by more
than a dollar.

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Figure 4 The Multiplier Effect

The Multiplier Effect

Price
Level

The multiplier effect refers to the additional

shifts in aggregate demand that result when
expansionary fiscal policy increases income and
p
g
therebyy increases consumer spending.

2. . . . but the multiplier

effect can amplify the
shift in aggregate
demand.
$20 billion

AD3
AD2
Aggregate demand, AD1
0
1. An increase in government purchases
of $20 billion initially increases aggregate
demand by $20 billion . . .
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Quantity of
Output

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06.09.2011

A Formula for the Spending Multiplier

A Formula for the Spending Multiplier

The formula for the multiplier is:

Multiplier = 1/(1 - MPC)
An important number in this formula is the
marginal propensity to consume (MPC).
(MPC)

If the MPC is 3/4, then the multiplier will be:

Multiplier = 1/(1 - 3/4) = 4
In this case, a $20 billion increase in
government spending generates $80 billion of
increased demand for goods and services.

It is the fraction of extra income that a household

consumes rather than saves.

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The Crowding-Out Effect

The Crowding-Out Effect

Fiscal policy may not affect the economy as

strongly as predicted by the multiplier.
An increase in government purchases causes
the interest rate to rise.
A higher interest rate reduces investment
spending.

This reduction in demand that results when a

fiscal expansion raises the interest rate is called
the crowding-out effect.
crowding-out
out effect tends to dampen the
The crowding
effects of fiscal policy on aggregate demand.

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Figure 5 The Crowding-Out Effect

The Crowding-Out Effect

(a) The Money Market

Interest
Rate

(b) The Shift in Aggregate Demand

Price
Level

Money
supply
2. . . . the increase in
spending increases
money demand . . .

$20 billion

4. . . . which in turn
partly offsets the
initial increase in
aggregate demand.

r2
3. . . . which
increases
the
equilibrium
interest
rate . . .

AD2
r

When the government increases its purchases

by $20 billion, the aggregate demand for goods
and services could rise by more or less than $20
billion, depending
p
g on whether the multiplier
p
effect or the crowding-out effect is larger.

AD3
M D2
Aggregate demand, AD1

Money demand, MD
0

Quantity fixed
by the Fed

Quantity
of Money

0
1. When an increase in government
purchases increases aggregate
demand . . .

Quantity
of Output

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06.09.2011

Changes in Taxes

Changes in Taxes

When the government cuts personal income

taxes, it increases households take-home pay.

The size of the shift in aggregate demand

resulting from a tax change is affected by the
multiplier and crowding-out effects.
households
It is also determined by the households
perceptions about the permanency of the tax
change.

Households save some of this additional income.

Households also spend
p
some of it on consumer
goods.
Increased household spending shifts the aggregatedemand curve to the right.

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USING POLICY TO STABILIZE

THE ECONOMY
Economic stabilization has been an explicit
goal of U.S. policy since the Employment Act
of 1946.

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The Case for Active Stabilization Policy

The Employment Act has two implications:
The government should avoid being the cause of
economic fluctuations.
The government should respond to changes in the
private economy in order to stabilize aggregate
demand.

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The Case against Active Stabilization Policy

Automatic Stabilizers

Some economists argue that monetary and

fiscal policy destabilizes the economy.
Monetary and fiscal policy affect the economy
with a substantial lag.
They suggest the economy should be left to
deal with the short-run fluctuations on its own.

Automatic stabilizers are changes in fiscal

policy that stimulate aggregate demand when
the economy goes into a recession without
policymakers
p
y
having
g to take any
y deliberate
action.
Automatic stabilizers include the tax system
and some forms of government spending.

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06.09.2011

Summary

Summary

Keynes proposed the theory of liquidity

preference to explain determinants of the
interest rate.
According to this theory, the interest rate
adjusts to balance the supply and demand for
money.

An increase in the price level raises money

demand and increases the interest rate.
A higher interest rate reduces investment and,
thereby, the quantity of goods and services
demanded.
The downward-sloping aggregate-demand
curve expresses this negative relationship
between the price-level and the quantity
demanded.

Copyright 2004 South-Western

Copyright 2004 South-Western

Summary

Summary

Policymakers can influence aggregate demand

with monetary policy.
An increase in the money supply will ultimately
lead to the aggregate
aggregate-demand
demand curve shifting to
the right.
A decrease in the money supply will ultimately
lead to the aggregate-demand curve shifting to
the left.

Policymakers can influence aggregate demand

with fiscal policy.
An increase in government purchases or a cut in
taxes shifts the aggregate
aggregate-demand
demand curve to the
right.
A decrease in government purchases or an
increase in taxes shifts the aggregate-demand
curve to the left.

Copyright 2004 South-Western

Summary

Copyright 2004 South-Western

Summary

When the government alters spending or taxes,

the resulting shift in aggregate demand can be
larger or smaller than the fiscal change.
The multiplier effect tends to amplify the
effects of fiscal policy on aggregate demand.
The crowding-out effect tends to dampen the
effects of fiscal policy on aggregate demand.

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Because monetary and fiscal policy can

influence aggregate demand, the government
sometimes uses these policy instruments in an
attempt
p to stabilize the economy.
y
Economists disagree about how active the
government should be in this effort.
Advocates say that if the government does not
respond the result will be undesirable fluctuations.
Critics argue that attempts at stabilization often turn
out destabilizing.
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