Chapter 21: HOW MONETARY & FISCAL POLICY

INFLUENCE THE AGGREGATE DEMAND

A. THE THEORY OF LIQUIDITY PREFERENCE............................................................................1
1. Review: The money market related to price..............................................................................1
2. Definition:..................................................................................................................................2
3. Money Supply...........................................................................................................................2
4. Money Demand.........................................................................................................................2
5. Equilibrium in the Money Market...............................................................................................2
6. The Downward Slope of the Aggregate-Demand Curve...........................................................2
B. HOW MONETARY POLICY INFLUENCES THE AGGREGATE DEMAND:................................3
1. Changes in the Money Supply..................................................................................................3
2. How does interest rate affect Consumption ?...........................................................................3
3. How does interest rate affect Investment ?...............................................................................3
4. Monetary Policy.........................................................................................................................3
5. The Role of Interest Rate Targets in Fed Policy.......................................................................4
6. The Zero Lower Bound.............................................................................................................4
C. HOW FISCAL POLICY INFLUENCES THE AGGREGATE DEMAND:........................................4
1. Tools:.........................................................................................................................................4
2. Effects:......................................................................................................................................5
3. Types:........................................................................................................................................5
D. USING POLICY TO STABILIZE THE ECONOMY.......................................................................6
1. The Case for Active Stabilization Policy....................................................................................6
2. Case study Keynesians in the White House:............................................................................6
3. The Case against Active Stabilization Policy:...........................................................................6
4. Automatic Stabilizers.................................................................................................................7

Note:
 Lines that have yellow highlight and question mark bullet is interacting questions.
Lines only have yellow highlight is the answer of the question above them.
 Lines that have green highlight and question mark bullet is questions asking for personal
opinion.

Headings has blue highlight is the important content of a part that would be asked for
conclusion
A. THE THEORY OF LIQUIDITY PREFERENCE
Review: The money market related to price
 Y= C+I+G+NX
 what are the three reasons that the demand curve is downward sloping
1) The wealth effect
2) The interest-rate effect
3) The exchange rate effect
 The wealth effect and the interest rate effect is relatively small.Thus, the most
important reason for the downward-sloping aggregate-demand curve is the
interest-rate effect.

1. Definition: Keynes’s theory that the interest rate adjusts to bring

money supply and money demand into balance.
 This theory is an explanation of the supply and demand for money and
how they relate to the interest rate in short-run.

2. Money Supply
 The Fed has control on the MS.

 For short-run, inflation rate is constant

→ The nominal interest rate and the real interest rate move together

 Because the Fed can control the size of the money supply directly
→ The supply of money is represented by a vertical supply curve.

3. Money Demand
 What liquidity means?
liquidity is the ease with which an asset can be converted into the
economy's medium of exchange
 People use money in 2 ways:
1) Saving and Investment: Less liquid, high return; more saving (decrease) MD
2) Spending: Money is the most liquid asset, no return; more spending (increase) MD

 The interest rate is the opportunity cost of holding money

→ High interest rate, hold less, lend more
→ MD is downward sloping.

 A household’s money demand reflects its “preference for liquidity”

4. Equilibrium in the Money Market

 The interest rate adjusts to bring money demand and money supply into balance.
→ For any given price level
→ The price level is stuck at some level
→ Influences the quantity of G&S demanded and the level of output.

 Interest rate is higher than the equilibrium interest rate

→ Households’ Q of money is less than the Fed supplied
→ People buy bonds or deposit funds
→ Increase the funds available for lending, decrease interest rates down
  Interest rate is lower than the equilibrium interest rate
→ Households’ Q of money is more than the Fed supplied
→ People sell bonds or withdraw funds
→ Decrease the funds available for lending, increase interest rates down

5. The Downward Slope of the Aggregate-Demand Curve

a. When the price level increase

→ the quantity of money that people need to hold becomes larger.
→ an increase in the price level leads to an increase in the demand for money,
shifting the money demand curve to the right.

b. For a fixed money supply, the interest rate must rise to balance the supply and
demand for money.

c. At a higher interest rate, the cost of borrowing and the return on saving both
increase.
→ consumers will choose to spend less and will be less likely to invest in new
housing. Firms will be less likely to borrow funds for new equipment or structures.
→ the quantity of goods and services purchased in the economy will fall.

Conclusion: As the price level increases, the quantity of goods and services
demanded falls. This is Keynes’s interest-rate effect.

 What tools do the Central Banks use to change money supply?

- Reserve requirement
- Discount rate
- Buy/sell government bonds in the Open market

B. HOW MONETARY POLICY INFLUENCES THE AGGREGATE

DEMAND:
1. Changes in the Money Supply
● When the Fed increases the money supply
→ lowers interest rates and increases the quantity of goods and services demanded
at any given price
→ shifting the aggregate demand curve to the right.

● And vice versa, when the Fed reduces the money supply
→raises interest rates and decreases the quantity of goods and services demanded
at any given price
→shifts the aggregate demand curve to the left.

2. How does interest rate affect Consumption ?

Interest rate is inversely proportional to spending
C=f(r-)
1) The higher the savings interest rate (lãi suất tiết kiệm tăng)
→ increase savings, income stays the same
→ Spending decreases
 2) High loan interest rate (lãi suất cho vay tăng)
→ loan reduction
→ Spending decrease
→Interest rate is inversely proportional to spending (Lãi suất tỉ lệ nghịch với chi tiêu)

3. How does interest rate affect Investment ?

Interest rate is inversely proportional to investment
I = f(r-)
 Because: The higher the interest rate
→Investors reduce borrowing money to invest
→Investment decreases
 Vice versa. Interest rate is inversely propotional to investment.

4. Monetary Policy
● Introduction: Planning Authority: Central Bank
● Objective: to change the economy's overall output and economy’s price level
● Tools
○ Reserve requirement
○ Discount rate
○ Open-market operation

5. The Role of Interest Rate Targets in Fed Policy

● When the economy in Recession: applying Expansionary monetary policy
(decrease reserve requirements, decrease discount rate, buy government bonds

● When the economy in Inflation: applying Contractionary monetary policy

(increase reserve requirements, increase discount rate, sell government bonds

 When the economy is experiencing high inflation, the central bank and
government should: Reduce money supply, increase interest rates
Right or wrong?
- Right

6. The Zero Lower Bound

● Normally, the banks would lower the interest rate during a recession (to promote
investment) and increase the interest rate during a boom (to control prices).

● Governments cannot encourage spending by lowering interest rates, because

people would simply hold cash instead
→ Monetary policy is lose ability to stimulate

● The Zero Lower Bound is the “liquidity trap”

● How to get out of the trap?→ Unconventional monetary policy.

→ Quantitative easing, ↑MD
→ Abenomics, ↑MS & ↑G
C. HOW FISCAL POLICY INFLUENCES THE AGGREGATE DEMAND:
Fiscal policy (definition) the setting of the level of government spending and

taxation by government policymakers.

1. Tools:

1.1. Changes in government purchases (overview)

 G (increase) → shift AD curve to the right

 G (decrease) → shift AD curve to the left
 Example: The US government places a $9 billion order for Covid-19 vaccine
doses with Pfizer.

1.2. Changes in taxes:

 Disposable income

 Tax (decrease) → shift AD curve to the right

 Tax (increase) → shift AD curve to the left

2. Effects:

2. 1. The multiplier effect:

 Definition of money multiplier: (the amount of money the banking system

generates with each dollar of reserves) or short explain about how money
multiplier works?

 Definition of the multiplier effect

 G (increase) → AD (increase) → Firm’s profit and worker’s income

(increase) → consumer spending (increase) → Demand on other goods
(increase) → The AD curve (shift larger) → multiplier effect

 G (increase) → Demand investment (increase) → investment accelerator

 Formula:
o MPC
o Size of the AD shift= Multiplier x G (initial)= 1/(1-MPC) x G (initial)
 3 practice questions (easy game)
 Other applications: A decrease in Nx ( purple sweet potato couldn’t be
exported in the Covid-19 pandemic)

2.2. The crowding-out effect:

  Definition of the crowding out effect

 G (increase) → ... → demand for goods (increase) → demand for money

(increase) → the interest rate (rise) → investment spending (decrease) →
demand residential and business investment goods (decrease) → The
AD curve (shift smaller)

3. Types:

3.1. Expansionary fiscal policy ( response Recession )

 Goals: increase AD & Real GDP

 Tools: Increase government spending and Decrease taxes

 Multiplier effect → Unemployment rate (decrease), Income level

(increase), Consumer spending( increase), Price level (increase), Real
wages (decrease), Net export (decrease)

 Crowding out effect: Deficit spending → Real interest rates (increase) →

investment spending (decrease)

3.2. Contractionary fiscal policy (response Inflation): SELF-STUDY

- Goals: decrease AD & Real GDP

D. USING POLICY TO STABILIZE THE ECONOMY

 In your opinion, do you think ưhether the goverment shold stabilize yhr econo
or not?

1. The Case for Active Stabilization Policy

1.1 The Case for Active Stabilization Policy: Return to the question at the
beginning of this chapter: When the president and Congress raise taxes,
how should the Federal Reserve respond?
1.2 Case study Keynesians in the White House:
 We dive into Kennedy’s policy

2. The Case against Active Stabilization Policy:

 Some economists argue that the government should avoid active use of
monetary and fiscal policy to try to stabilize the economy due to the lags
2.1 The lags in monetary policy
2.2 The lags in fiscal policy
 The main reasons for the lags of both policies: imprecise forecasting, slow
preparation and remaining effects of the previous recession.
 Can you recall what is fiscal policy: the setting of the level of
government spending and taxation by government policymakers

3. How Large Is the Fiscal Policy Multiplier?

 About multipliers: Across the globe countries have countered the recession by
cutting taxes and by boosting government spending. There were stimulus
packages offered to deal with the situation.
 The size of the multiplier is bound to vary according to economic conditions as
followed:
o For an economy operating at full capacity (it means there is no spare
resources, any increase in government demand would just replace
spending elsewhere) → leads to the fiscal multiplier should be zero
o When there is a recession, when workers and factories are available, a
fiscal boost can increase overall demand. And if the initial stimulus
triggers a cascade of expenditure among consumers and businesses,
the multiplier can be well above one
o The overall size of the fiscal multiplier also depends on how people
react to higher government borrowing. if interest rates rise in response
to government borrowing then consumers would spend less and
investment spending would be reduced
 To explain how large the fiscal policy is, we should focus on the economic
conditions but don’t forget about the lags it may cause when implementing.
This topic raises a lot of opinions and controversies among economists.

4. Automatic Stabilizers
 The economy would be more stable if policymakers could find a way to avoid
some of these lags. In fact, they have. Automatic stabilizers are changes in
fiscal policy that stimulate aggregate demand when the economy goes into a
recession without policymakers having to take any action.
 The most vital automatic stabilizer is the tax system
 overnment spending also acts as an automatic stabilizer
 The automatic stabilizers in the U.S. economy are not sufficiently strong to
prevent recessions completely