1

The Influence of
Monetary and Fiscal Policy
on Aggregate Demand
Lecture 20
34
1 1
In this chapter,
look for the answers to these questions:
How does the interest-rate effect help explain the
slope of the aggregate-demand curve?
How can the central bank use monetary policy to
shift the AD curve?
In what two ways does fiscal policy affect
aggregate demand?
What are the arguments for and against
using policy to try to stabilize the economy?
2 2
Aggregate Demand
This chapter focuses on the short-run effects
of fiscal and monetary policy, which work through
aggregate demand.
Recall, the AD curve slopes downward for three
reasons:
The wealth effect
The interest-rate effect
The exchange-rate effect
A supply-demand model that helps explain the
interest-rate effect and how monetary policy affects
aggregate demand.
3 3
The Theory of Liquidity Preference
A simple theory of the interest rate (denoted r) states that r
adjusts to balance supply and demand for money
Money supply: assume fixed by central bank, does not
depend on interest rate.
Money demand reflects how much wealth people want to
hold in liquid form.
For simplicity, suppose household wealth includes only two
assets:
Money liquid but pays no interest
Bonds pay interest but not as liquid
A households money demand reflects its preference for
liquidity.
The variables that influence money demand:
Y, r, and P.

4 4
Money Demand
Suppose real income (Y) rises. Other things
equal, what happens to money demand?
If Y rises:
Households want to buy more g&s,
so they need more money.
To get this money, they attempt to sell some of
their bonds.
i.e., an increase in Y causes
an increase in money demand, other things equal.
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How r Is Determined
MS curve is vertical:
Changes in r do not
affect MS, which is
fixed by the Fed.
MD curve is
downward sloping:
A fall in r increases
money demand.
M
Interest
rate
MS
MD
1
r
1
Quantity fixed
by the Fed
Eqm
interest
rate
2
6 6
How the Interest-Rate Effect Works
Y
P
M
Interest
rate
AD
MS
MD
1
MD
2
P
2
P
1
Y
1
Y
2
r
2
r
1
A fall in P reduces money demand, which lowers r.
A fall in r increases I and the quantity of g&s demanded.
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Monetary Policy and Aggregate Demand
To achieve macroeconomic goals, the Fed can
use monetary policy to shift the AD curve.
The Feds policy instrument is MS.
The news often reports that the Fed targets the
interest rate.
More precisely, the federal funds rate, which
banks charge each other on short-term loans
To change the interest rate and shift the AD curve,
the Fed conducts open market operations
to change MS.
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The Effects of Reducing the Money Supply
Y
P
M
Interest
rate
AD
1
MS
1
MD

P
1
Y
1
r
1
MS
2
r
2
AD
2
Y
2
The BSP can raise r by reducing the money supply.
An increase in r reduces the quantity of g&s demanded.
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Liquidity traps
Monetary policy stimulates aggregate demand by
reducing the interest rate.
Liquidity trap: when the interest rate is zero
In a liquidity trap, mon. policy may not work, since
nominal interest rates cannot be reduced further.
However, central bank can make real interest
rates negative by raising inflation expectations.
Also, central bank can conduct open-market ops
using other assetslike mortgages and corporate
debtthereby lowering rates on these kinds of
loans. The Fed pursued this option in 20082009.
10 10
Fiscal Policy and Aggregate Demand
Fiscal policy: the setting of the level of govt
spending and taxation by govt policymakers
Expansionary fiscal policy
an increase in G and/or decrease in T,
shifts AD right
Contractionary fiscal policy
a decrease in G and/or increase in T,
shifts AD left
Fiscal policy has two effects on AD...
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1. The Multiplier Effect
If the govt buys $20b of planes from Boeing,
Boeings revenue increases by $20b.
This is distributed to Boeings workers (as wages)
and owners (as profits or stock dividends).
These people are also consumers and will spend
a portion of the extra income.
This extra consumption causes further increases
in aggregate demand.
Multiplier effect: the additional shifts in AD
that result when fiscal policy increases income
and thereby increases consumer spending
3
12 12
1. The Multiplier Effect
A $20b increase in G
initially shifts AD
to the right by $20b.
The increase in Y
causes C to rise,
which shifts AD
further to the right.
Y
P
AD
1
P
1
AD
2
AD
3
Y
1
Y
3
Y
2
$20 billion
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Marginal Propensity to Consume
How big is the multiplier effect?
It depends on how much consumers respond to
increases in income.
Marginal propensity to consume (MPC):
the fraction of extra income that households
consume rather than save
E.g., if MPC = 0.8 and income rises $100,
C rises $80.
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Notation: G is the change in G,
Y and C are the ultimate changes in Y and C
Y = C + I + G + NX identity
Y = C + G I and NX do not change
Y = MPC Y + G because C = MPC Y
solved for Y
1
1 MPC
Y = G
A Formula for the Multiplier
The multiplier
15 15
The size of the multiplier depends on MPC.
E.g., if MPC = 0.5 multiplier = 2
if MPC = 0.75 multiplier = 4
if MPC = 0.9 multiplier = 10

A Formula for the Multiplier
1
1 MPC
Y = G
The multiplier
A bigger MPC means
changes in Y cause
bigger changes in C,
which in turn cause
bigger changes in Y.
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Other Applications of the Multiplier Effect
The multiplier effect:
Each $1 increase in G can generate
more than a $1 increase in agg demand.
Also true for the other components of GDP.
Example: Suppose a recession overseas
reduces demand for U.S. net exports by $10b.
Initially, agg demand falls by $10b.
The fall in Y causes C to fall, which further
reduces agg demand and income.
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2. The Crowding-Out Effect
Fiscal policy has another effect on AD
that works in the opposite direction.
A fiscal expansion raises r,
which reduces investment,
which reduces the net increase in agg demand.
So, the size of the AD shift may be smaller than
the initial fiscal expansion.
This is called the crowding-out effect.
4
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How the Crowding-Out Effect Works
Y
P
M
Interest
rate
AD
1
MS
MD
2
MD
1
P
1
r
1
r
2
A $20b increase in G initially shifts AD right by $20b
But higher Y increases MD and r, which reduces AD.
AD
3
AD
2
Y
1
Y
2
$20 billion
Y
3
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Changes in Taxes
A tax cut increases households take-home pay.
Households respond by spending a portion of this
extra income, shifting AD to the right.
The size of the shift is affected by the multiplier
and crowding-out effects.
Another factor: whether households perceive the
tax cut to be temporary or permanent.
A permanent tax cut causes a bigger increase
in Cand a bigger shift in the AD curvethan
a temporary tax cut.
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Fiscal Policy and Aggregate Supply
Most economists believe the short-run effects of
fiscal policy mainly work through agg demand.
But fiscal policy might also affect agg supply.
Recall one of the Ten Principles from Chapter 1:
People respond to incentives.
A cut in the tax rate gives workers incentive to
work more, so it might increase the quantity of
g&s supplied and shift AS to the right.
People who believe this effect is large are called
Supply-siders.
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Fiscal Policy and Aggregate Supply
Govt purchases might affect agg supply.
Example:
Govt increases spending on roads.
Better roads may increase business
productivity, which increases the quantity of g&s
supplied, shifts AS to the right.
This effect is probably more relevant in the long
run: it takes time to build the new roads and put
them into use.
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The Case for Active Stabilization Policy
Keynes: Animal spirits cause waves of
pessimism and optimism among households
and firms, leading to shifts in aggregate demand
and fluctuations in output and employment.
Also, other factors cause fluctuations, e.g.,
booms and recessions abroad
stock market booms and crashes
If policymakers do nothing, these fluctuations
are destabilizing to businesses, workers,
consumers.
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The Case for Active Stabilization Policy
Proponents of active stabilization policy
believe the govt should use policy
to reduce these fluctuations:
When GDP falls below its natural rate,
use expansionary monetary or fiscal policy
to prevent or reduce a recession.
When GDP rises above its natural rate,
use contractionary policy to prevent or reduce
an inflationary boom.

5
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Keynesians in the White House
1961:
John F Kennedy pushed for a
tax cut to stimulate agg demand.
Several of his economic advisors
were followers of Keynes.
2009:
Barack Obama pushed for
spending increases and tax cuts
to increase agg demand in the
face of a deep recession.
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The Case Against Active Stabilization Policy
Monetary policy affects economy with a long lag:
Firms make investment plans in advance,
so I takes time to respond to changes in r.
Most economists believe it takes at least
6 months for monetary policy to affect output
and employment.
Fiscal policy also works with a long lag:
Changes in G and T require acts of Congress.
The legislative process can take months or
years.
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The Case Against Active Stabilization Policy
Due to these long lags, critics of active policy
argue that such policies may destabilize the
economy rather than help it:
By the time the policies affect agg demand,
the economys condition may have changed.
These critics contend that policymakers should
focus on long-run goals like economic growth
and low inflation.
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Automatic Stabilizers
Automatic stabilizers:
changes in fiscal policy that stimulate aggregate demand
when economy goes into recession, without policymakers
having to take any deliberate action
Examples:
The tax system
In recession, taxes fall automatically,
which stimulates agg demand.
Govt spending
In recession, more people apply for public assistance
(welfare, unemployment insurance).
Govt spending on these programs automatically rises,
which stimulates agg demand.

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interest sensitivity or insensitivity of planned investment The
responsiveness of planned investment spending to changes in the
interest rate. Interest sensitivity means that planned investment
spending changes a great deal in response to changes in the
interest rate; interest insensitivity means little or no change in
planned investment as a result of changes in the interest rate.
Effects of an expansionary fiscal policy:
increase not did if than less increases r Y
I r M Y G
d

Expansionary Fiscal Policy: An Increase in Government
Purchases (G) or a Decrease in Net Taxes (T)
Policy Effects in the Goods and Money Markets
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Effects of an expansionary monetary policy:
increase not did if than less decreases
d
M r
d s
M Y I r M
Expansionary Monetary Policy: An Increase in the
Money Supply
Policy Effects in the Goods and Money Markets
6
30
contractionary fiscal policy A decrease in
government spending or an increase in net taxes
aimed at decreasing aggregate output (income) (Y).
Effects of a contractionary fiscal policy:
decrease not did if than less decreases
or
r Y
I r M Y T G
d

Contractionary Fiscal Policy: A Decrease in Government
Spending (G) or an Increase in Net Taxes (T)
Policy Effects in the Goods and Money Markets
31
contractionary monetary policy A decrease in the
money supply aimed at decreasing aggregate output
(income) (Y).
Effects of a contractionary monetary policy:
decrease not did if than less increases
d
M r
d s
M Y I r M
Policy Effects in the Goods and Money Markets
Contractionary Monetary Policy: A Decrease in the
Money Supply
33 33
CONCLUSION
Policymakers need to consider all the effects of
their actions. For example,
When Congress cuts taxes, it should consider
the short-run effects on agg demand and
employment, and the long-run effects
on saving and growth.
When the Fed reduces the rate of money
growth, it must take into account not only the
long-run effects on inflation but the short-run
effects on output and employment.
SUMMARY
In the theory of liquidity preference, the interest
rate adjusts to balance the demand for money
with the supply of money.
The interest-rate effect helps explain why the
aggregate-demand curve slopes downward:
an increase in the price level raises money
demand, which raises the interest rate, which
reduces investment, which reduces the aggregate
quantity of goods & services demanded.
An increase in the money supply causes the
interest rate to fall, which stimulates investment
and shifts the aggregate demand curve rightward.

SUMMARY
Expansionary fiscal policya spending increase
or tax cutshifts aggregate demand to the right.
Contractionary fiscal policy shifts aggregate
demand to the left.
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.

SUMMARY
Economists disagree about how actively
policymakers should try to stabilize the
economy.
Some argue that the government should use
fiscal and monetary policy to combat
destabilizing fluctuations in output and
employment.
Others argue that policy will end up destabilizing
the economy because policies work with long
lags.