Chapter 24: The Influence of Monetary and Fiscal Policy on Aggregate Demand: 24 Chapter summary

Book Title: Essentials of Economics

Printed By: Kevin Pham ([email protected])
© 2024 Cengage Learning, Inc., Cengage Learning, Inc.

24 Chapter Overview with Helpful Hints

Chapter Review

Introduction Earlier, we demonstrated that shifts in aggregate demand and short-run

aggregate supply cause short-run fluctuations in the economy around its long-run trend and
showed how monetary and fiscal policymakers might shift aggregate demand to stabilize the
economy. In this chapter, we address the theory behind stabilization policies and some of
the shortcomings of stabilization policy.

How Monetary Policy Influences Aggregate Demand

The aggregate-demand curve shows the quantity of goods and services demanded at each
price level. Recall that aggregate demand slopes downward due to the wealth effect, the
interest-rate effect, and the exchange-rate effect. Because money is a small part of total
wealth and since the international sector is a small part of the U.S. economy, the most
important reason for the downward slope of U.S. aggregate demand is the interest-rate
effect.

The interest rate is a key determinant of aggregate demand. To see how monetary policy
affects aggregate demand, we develop Keynes’s theory of interest rate determination, called
the theory of liquidity preference. This theory suggests that the interest rate is determined by
the supply and demand for money. Note that the interest rate being determined is both the
nominal and the real interest rate because, in the short run, expected inflation is
unchanging, so changes in the nominal rate equal changes in the real rate.

Recall that the money supply is determined by the Fed and can be fixed at whatever level
the Fed chooses. Therefore, the money supply is unaffected by the interest rate and is a
vertical line in Exhibit 1. People have a demand for money because money, as the
economy’s most liquid asset, is a medium of exchange. Hence, people have a demand for
it, even though it has little or no rate of return, because it can be used to buy things. The
interest rate is the opportunity cost of holding money. When the interest rate is high, people
hold more wealth in interest-bearing bonds and economize on their money holdings. Thus,
the quantity of money demanded is reduced. This is shown in Exhibit 1. The equilibrium
interest rate is determined by the intersection of money supply and money demand.
In the long run, the interest rate is determined by the supply and demand for loanable funds.
In the short run, the interest rate is determined by the supply and demand for money. This
poses no conflict because each theory highlights the behavior of interest rates over a
different time horizon.

In the long run, output is fixed by factor supplies and technology; the interest rate adjusts to
balance the supply and demand for loanable funds, and the price level adjusts to balance
the supply and demand for money.

In the short run, the price level is sticky and cannot adjust. For any given price level, the
interest rate adjusts to balance the supply and demand for money. The interest rate
influences aggregate demand and, thus, output.

We can use the theory of liquidity preference to add precision to our explanation of the
negative slope of the aggregate-demand curve. Recall from previous chapters that the
demand for money is positively related to the price level because at higher prices, people
need more money to buy the same quantity of goods. Thus, a higher price level shifts
money demand to the right, as shown in Exhibit 2, panel (a). With a fixed money supply, a
larger money demand raises the interest rate. A higher interest rate reduces investment
expenditures and causes the quantity demanded of goods and services to fall in Exhibit 2,
panel (b).

Returning to the point of this section: How does monetary policy influence aggregate
demand? Suppose the Fed buys government bonds, shifting the money supply to the right
as in Exhibit 3, panel (a). The interest rate falls, reducing the cost of borrowing for
investment. Hence, the quantity of goods and services demanded at each price level
increases, shifting aggregate demand to the right in Exhibit 3, panel (b).
The Fed can implement monetary policy by targeting the money supply or interest rates. In
recent years, the Fed has targeted the interest rate because the money supply is hard to
measure and because money demand fluctuates, causing fluctuations in interest rates,
aggregate demand, and output for a given money supply. In particular, the Fed has targeted
the federal funds rate—the interest rate banks charge each other for short-term loans.
Whether the Fed targets the money supply or interest rates has little effect on our analysis
because every monetary policy can be described in terms of the money supply or the
interest rate. For example, the monetary policy expansion used to increase aggregate
demand in the example above could be described as an increase in the money supply or a
decrease in the interest rate target. Since 2008, when the Fed lowers its federal funds rate
target, it also lowers the interest it pays on bank reserves, causing banks to increase their
lending, which automatically increases the money supply.

Expansionary monetary policy may fail to stimulate the economy if the interest rate has
reached its zero lower bound. This is known as a liquidity trap. The Fed may still be able to
expand the economy by committing to keeping interest rates low for an extended period
(known as forward guidance), increasing inflationary expectations and reducing the real
interest rate, buying assets like mortgage-backed securities and longer-term government
bonds (known as quantitative easing), which lowers interest rates on those instruments,
and targeting higher inflation to lower real interest rates.

How Fiscal Policy Influences Aggregate Demand

Fiscal policy refers to the government’s choices of the levels of government purchases and
taxes. While fiscal policy can influence growth in the long run, its primary impact in the short
run is on aggregate demand.

An increase in government purchases of $20 billion to buy military aircraft is reflected in a

rightward shift in the aggregate-demand curve. There are two reasons why the actual
rightward shift may be greater than or less than $20 billion:

The multiplier effect: When the government spends $20 billion on aircraft, incomes rise in
the form of wages and profits of the aircraft manufacturer. The recipients of the new income
raise their spending on consumer goods, which raises the incomes of people in other firms,
which raises their consumption spending, and so on for many rounds. Because aggregate
demand may rise by much more than the increase in government purchases, government
purchases are said to have a multiplier effect on aggregate demand. There is a formula for
the size of the multiplier effect. It says that for every dollar the government spends,
aggregate demand shifts to the right by 1/(1 – MPC), where MPC stands for the marginal
propensity to consume—the fraction of extra income that a household spends on
consumption. For example, if the MPC is 0.75, the multiplier is 1/(1 – 0.75) = 1/0.25 = 4,
which means that $1 of government spending shifts aggregate demand to the right by a
total of $4. A larger MPC generates a larger multiplier.

In addition to the multiplier, the increase in purchases may cause firms to increase their
investment expenditures on new equipment, further increasing the response of aggregate
demand to the initial increase in government purchases. This is known as the investment
accelerator.

Thus, the aggregate-demand curve may shift by more than the change in government
purchases.

The logic of the multiplier effect applies to other changes in spending besides government
purchases. For example, shocks to consumption, investment, and net exports may have a
multiplier effect on aggregate demand.

The crowding-out effect: The crowding-out effect works in the opposite direction of the
multiplier. An increase in government purchases (as in the case above) raises incomes,
which shifts the demand for money to the right. This raises the interest rate, which lowers
investment. Thus, an increase in government purchases increases the interest rate and
reduces, or crowds out, private investment. Due to crowding out, the aggregate-demand
curve may shift right by less than the increase in government purchases.

Whether the final shift in the aggregate-demand curve is greater than or less than the
original change in government spending depends on which is larger: the multiplier effect or
the crowding-out effect.

The other half of fiscal policy is taxation. A reduction in taxes increases households’ take-
home pay and, hence, increases their consumption. Therefore, a decrease in taxes shifts
aggregate demand to the right, while an increase shifts aggregate demand to the left. The
size of the shift in aggregate demand depends on the relative size of the multiplier and
crowding-out effects described above. In addition, a reduction in taxes that is perceived by
households to be permanent improves the financial condition of the household a great
amount and increases aggregate demand substantially. A change in taxes that is perceived
to be temporary has a much smaller effect on aggregate demand.

The sizes of fiscal policy multipliers are very difficult to predict.

Finally, fiscal policy might have an effect on aggregate supply for two reasons. First, a
reduction in taxes might increase the incentive to work and cause aggregate supply to shift
right. Supply siders believe this effect could be so large that tax revenue could increase.
Most economists do not believe this is the normal case. Second, government purchases of
capital, such as roads and bridges, may increase the amount of goods supplied at each
price level and shift the aggregate-supply curve to the right. This effect is more likely to be
important in the long run.

Using Policy to Stabilize the Economy

Keynes (and his followers) argued that the government should actively use monetary and
fiscal policies to stabilize aggregate demand and, as a result, output and employment.

The Employment Act of 1946 holds the federal government responsible for promoting full
employment and production. The act has two implications: (1) The government should not
be the cause of fluctuations, so it should avoid sudden changes in fiscal and monetary
policy, and (2) the government should respond to changes in the private economy to
stabilize it. For example, if consumer pessimism reduces aggregate demand, the proper
amount of expansionary monetary or fiscal policy could stimulate aggregate demand to its
original level, thereby avoiding a recession. Alternatively, if excessive optimism increases
aggregate demand, contractionary monetary or fiscal policy could dampen aggregate
demand to its original level, thereby avoiding inflationary pressures. Failure to actively
stabilize the economy may allow for unnecessary fluctuations in output and employment.

Some economists argue that the government should not use monetary and fiscal policy to
try to stabilize short-run fluctuations in the economy. While they agree that, in theory, activist
policy can stabilize the economy, they feel that, in practice, monetary and fiscal policy affect
the economy with a substantial lag. The lag for monetary policy is at least six months, so it
may be hard for the Fed to “fine-tune” the economy. Fiscal policy has a long political lag
because it takes months or years to pass spending and taxation legislation. These lags
mean that activist policy could be destabilizing because expansionary policy could
accidentally increase aggregate demand during periods of excessive private aggregate
demand, and contractionary policy could accidentally decrease aggregate demand during
periods of deficient private aggregate demand.

Automatic stabilizers are changes in fiscal policy that automatically stimulate aggregate
demand in a recession so policymakers do not have to take deliberate action. The tax
system automatically lowers tax collections during a recession when incomes and profits
fall. Government spending automatically rises during a recession because unemployment
benefits and welfare payments rise. Hence, both the tax and government spending systems
increase aggregate demand during a recession. A strict balanced budget rule would
eliminate automatic stabilizers because the government would have to raise taxes or lower
expenditures during a recession.

Helpful Hints

1. A larger MPC generates a larger multiplier. If the MPC were 0.80, suggesting that
people spend 80 percent of an increase in income on consumption goods, the
multiplier is 1/(1 – 0.80) = 5. This is larger than the multiplier generated in the text
when using an MPC of 0.75. There is an intuitive appeal to this result. If people spend
a higher percentage of an increase in income on consumption goods, any new
government purchase will have an even larger multiplier effect and shift the
aggregate-demand curve farther to the right.
 2. The multiplier works in both directions. If the government reduces purchases, the
multiplier effect suggests that the aggregate-demand curve will shift to the left by a
greater amount than the initial reduction in government purchases. When the
government reduces purchases, wages and profits of people are reduced, and they
reduce their consumption expenditures, and so on, creating multiple contractions in
aggregate demand.

3. Activist stabilization policy has many descriptive names. Activist stabilization policy is
the use of discretionary monetary and fiscal policies to manage aggregate demand in
such a way as to minimize the fluctuations in output and maintain output at the long-
run natural level. As such, activist stabilization policy is sometimes called discretionary
policy to distinguish it from automatic stabilizers. It is also called aggregate demand
management because monetary and fiscal policies are used to adjust or manage total
spending in the economy. Finally, since policymakers attempt to counter the business
cycle by reducing aggregate demand when it is too high and by increasing aggregate
demand when it is too low, stabilization policy is sometimes referred to as
countercyclical policy.

4. Activist stabilization policy can be used to move output toward the long-run natural
level from levels of output that are either above or below the natural level of output. As
in the previous chapter, most of the examples of stabilization policy in the text assume
the economy is in a recession—a period when output is below the long-run natural
level. However, activist stabilization policy can be used to reduce aggregate demand
and output in periods when output exceeds the long-run natural level. When output
exceeds the natural level, we sometimes say that the economy is overheating
because, left alone, the economy will adjust to a higher level of expected prices and
wages, and output will fall to the natural level (short-run aggregate supply shifts left).
Most economists believe that the Federal Reserve needs political independence to
combat an overheating economy. This is because the activist policy prescription for an
overheating economy is a reduction in aggregate demand, which usually faces
political opposition. That is, “taking away the punch bowl just as the party gets going”
is not likely to be politically popular.

Chapter 24: The Influence of Monetary and Fiscal Policy on Aggregate Demand: 24 Chapter summary
Book Title: Essentials of Economics
Printed By: Kevin Pham ([email protected])
© 2024 Cengage Learning, Inc., Cengage Learning, Inc.

© 2024 Cengage Learning Inc. All rights reserved. No part of this work may by reproduced or used in any form or by any means -
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