The Influence of Monetary and Fiscal Policy on

Aggregate Demand
HOW MONETARY POLICY INFLUENCES
AGGREGATE DEMAND
 The
The wealth The interest-
exchange-
effect rate effect
rate effect
 The
The wealth The interest-
exchange-
effect rate effect
rate effect
 A lower price level raises the real value of
household’s money holdings, which are part of
their wealth. Higher real wealth stimulates
consumer spending and thus inrease the
quantity of goods and services demanded.

The wealth effect

 The
The wealth The interest-
exchange-
effect rate effect
rate effect
A lower price level reduces the amount of money
people want to hold. As people try to lend out
their excess money holdings, the interest rate
falls. The lower interest rate stimulates
investment spending and thus increases the
quantity of goods and services demanded.

The interest-rate effect

 The
The wealth The interest-
exchange-
effect rate effect
rate effect
 When a lower price level reduces the interest
rate, investors move some of their funds overseas
in search of higher return. This movement of
funds causes the real value of the domestic
currency to fall in the market for foreign goods.
This change in the real exchange rate stimulates
spending on net exports and thus increase the
quantity of goods and services demanded.

The exchange-rate effect

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

HOW MONETARY
POLICY INFLUENCES
AGGREGATE DEMAND
The Theory of Liquidity Preference

• Keynes developed the theory of liquidity preference

in order to explain what factors determine the
economy’s interest rate.
• According to the theory, the interest rate adjusts to
balance the supply and demand for money.
The Theory of Liquidity Preference

• Money Supply
• 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.
The Theory of Liquidity Preference

• Money Demand
• 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.
The Theory of Liquidity Preference

• 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.
The Theory of Liquidity Preference

• Equilibrium in the Money Market

• Assume the following about the economy:
• 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.
 Figure 1 Equilibrium in the Money Market

Interest
Rate
Money
supply

r1

Equilibrium
interest
rate
r2
Money
demand

0 Md Quantity fixed M2d Quantity of

by the Fed Money
Copyright © 2004 South-Western
The Downward Slope of the Aggregate
Demand Curve
• 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.
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 (b) The Aggregate-Demand Curve

Interest Money Price

Rate supply Level
2. . . . increases the
demand for money . . .

r2 P2
Money demand at
price level P2 , MD2
r 1. An P
3. . . .
which increase
Money demand at in the Aggregate
increases
price level P , MD price demand
the
equilibrium 0 level . . . 0
Quantity fixed Quantity Y2 Y Quantity
interest
by the Fed of Money of Output
rate . . .
4. . . . which in turn reduces the quantity
of goods and services demanded.

Copyright © 2004 South-Western

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.
 Figure 3 A Monetary Injection

(a) The Money Market (b) The Aggregate-Demand Curve

Interest Price
Rate Money MS2 Level
supply,
MS

r 1. When the Fed P

increases the
money supply . . .
2. . . . the r2
AD2
equilibrium
interest rate Money demand Aggregate
falls . . . at price level P demand, AD
0 Quantity 0 Y Y Quantity
of Money of Output
3. . . . which increases the quantity of goods
and services demanded at a given price level.

Copyright © 2004 South-Western

Changes in the Money Supply

• When the Fed increases the money supply, it

lowers the interest rate and increases the quantity
of goods and services demanded at any given price
level, shifting aggregate-demand 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.
The Role of Interest-Rate Targets in Fed Policy

• 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.
HOW FISCAL POLICY INFLUENCES
AGGREGATE DEMAND
• Fiscal policy refers to the government’s 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 indirect—
through the spending decisions of firms or
households.
• When the government alters its own purchases of
goods or services, it shifts the aggregate-demand
curve directly.
Changes in Government Purchases

• There are two macroeconomic effects from the

change in government purchases:
• The multiplier effect
• The crowding-out effect
The Multiplier Effect

• Government purchases are said to have a multiplier

effect on aggregate demand.
• Each dollar spent by the government can raise the
aggregate demand for goods and services by more than
a dollar.
The Multiplier Effect

• The multiplier effect refers to the additional shifts

in aggregate demand that result when
expansionary fiscal policy increases income and
thereby increases consumer spending.
 Figure 4 The Multiplier Effect

Price
Level

2. . . . but the multiplier

effect can amplify the
shift in aggregate
demand.

$20 billion

AD3
AD2
Aggregate demand, AD1
0 Quantity of
1. An increase in government purchases Output
of $20 billion initially increases aggregate
demand by $20 billion . . .
Copyright © 2004 South-Western
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).
• It is the fraction of extra income that a household
consumes rather than saves.
A Formula for the Spending Multiplier

• 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.
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.
The Crowding-Out Effect

• This reduction in demand that results when a fiscal

expansion raises the interest rate is called the
crowding-out effect.
• The crowding-out effect tends to dampen the
effects of fiscal policy on aggregate demand.
 Figure 5 The Crowding-Out Effect

(a) The Money Market (b) The Shift in Aggregate Demand

Interest Price
Money 4. . . . which in turn
Rate Level
supply partly offsets the
2. . . . the increase in $20 billion initial increase in
spending increases aggregate demand.
money demand . . .
r2

3. . . . which
increases AD2
the r
AD3
equilibrium M D2
interest
rate . . . Aggregate demand, AD1
Money demand, MD
0 Quantity fixed Quantity 0 Quantity
by the Fed of Money 1. When an increase in government of Output
purchases increases aggregate
demand . . .

Copyright © 2004 South-Western

The Crowding-Out Effect

• 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 on whether the multiplier effect or the
crowding-out effect is larger.
Changes in Taxes

• When the government cuts personal income taxes,

it increases households’ take-home pay.
• Households save some of this additional income.
• Households also spend some of it on consumer goods.
• Increased household spending shifts the aggregate-
demand curve to the right.
Changes in Taxes

• The size of the shift in aggregate demand resulting

from a tax change is affected by the multiplier and
crowding-out effects.
• It is also determined by the households’
perceptions about the permanency of the tax
change.
USING POLICY TO STABILIZE THE
ECONOMY
• Economic stabilization has been an explicit goal of
U.S. policy since the Employment Act of 1946.
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.
The Case against Active Stabilization Policy

• 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

• Automatic stabilizers are changes in fiscal policy

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