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Lec2.8.1 Slides

The document discusses how monetary policy influences aggregate demand. It explains the theory of liquidity preference and how the interest rate adjusts to balance money supply and demand. It analyzes what happens when the central bank increases or decreases the money supply, and how this shifts the aggregate demand curve in closed and open economies.

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5 views18 pages

Lec2.8.1 Slides

The document discusses how monetary policy influences aggregate demand. It explains the theory of liquidity preference and how the interest rate adjusts to balance money supply and demand. It analyzes what happens when the central bank increases or decreases the money supply, and how this shifts the aggregate demand curve in closed and open economies.

Uploaded by

manandeepamazon
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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THE INFLUENCE OF

MONETARY POLICY ON
AGGREGATE DEMAND

15-1
HOW MONETARY POLICY
INFLUENCES AGGREGATE DEMAND
 The aggregate-demand curve slopes downward because of:

1. The wealth effect: A lower price level raises the real value of
households’ money holdings, and higher real wealth stimulates consumer
spending.

2. The interest-rate effect: A lower price level lowers the interest rate
as people try to lend out their excess money holdings, and the lower
interest rate stimulates investment spending.

 The interest-rate effect is the most important reason for the


downward slope of the aggregate-demand curve. 15-2
HOW MONETARY POLICY
INFLUENCES AGGREGATE DEMAND
THE THEORY OF LIQUIDITY PREFERENCE
 The theory of liquidity preference the interest rate adjusts to
bring money supply and money demand into balance
 The real interest rate is the interest rate corrected for the effects
of inflation
 When there is no inflation, the two rates are the same
 In developing the theory of liquidity preference, we assume that
the expected inflation rate is constant
 In this case, nominal and real interest rates differ by a constant.
15-3
HOW MONETARY POLICY
INFLUENCES AGGREGATE DEMAND
THE THEORY OF LIQUIDITY PREFERENCE: MONEY SUPPLY
 The Bank of Canada alters the money supply using two methods:
1. Changing the bank rate
2. Open-market operations
 Buying and selling federal government bonds
 Foreign exchange market operations
 Assume that the quantity of money supplied in the economy is fixed
at whatever level the Bank of Canada decides to set it
15-4
HOW MONETARY POLICY
INFLUENCES AGGREGATE DEMAND
THE THEORY OF LIQUIDITY PREFERENCE: MONEY DEMAND
 Although many factors determine the quantity of money demanded, the one
emphasized by the theory of liquidity preference is the interest rate.
 An increase in the interest rate raises the cost of holding money and, as a result, reduces
the quantity of money demanded
 The other key determinant of the quantity of money demanded is the fact that money
is used to buy goods and services.
 For a given interest rate, an increase in the dollar value of transactions causes the
demand for money to increase.
 The price level
 Real GDP
 The product of these two measures is the dollar value of all transactions in the economy
15-5
FIGURE 15.2
The Demand for Money

 Because the interest rate measures the


opportunity cost of holding
noninterest-bearing money instead of
interest-bearing bonds, an increase in
the interest rate reduces the quantity
of money demanded.

 A downward-sloping demand curve


represents this negative relationship.

15-6
HOW MONETARY POLICY
INFLUENCES AGGREGATE DEMAND
THE THEORY OF LIQUIDITY PREFERENCE: MONEY
DEMAND (CONT’D)
 For any given interest rate, an increase in the dollar value of transactions causes
the demand for money to increase.

 As a result, the money-demand curve shifts to the right.

 On the other hand, for any given interest rate, a decrease in the dollar value of
transactions causes the demand for money to decrease.

 As a result, the money-demand curve shifts to the left. 15-7


FIGURE 15.3
Shifts in the Demand for Money

15-8
HOW MONETARY POLICY
INFLUENCES AGGREGATE DEMAND
THE THEORY OF LIQUIDITY PREFERENCE: EQUILIBRIUM
 According to the theory of liquidity preference, the interest
rate adjusts to balance the supply and demand for money
 The interest rate that balances the supply and demand for
money is called the equilibrium interest rate

15-9
FIGURE 15.4
Equilibrium in the
Money Market

15-10
HOW MONETARY POLICY
INFLUENCES AGGREGATE DEMAND
 If the overall level of prices in the economy rises.
 What happens to the interest rate that balances the supply and
demand for money, and how does that change affect the quantity
of goods and services demanded?
 When prices are higher more money is needed every time to buy
a good or service
 As a result, people will choose to hold a larger quantity of money
 An increase in the price level shifts the money-demand curve to
the right from 15-11
FIGURE 15.5
The Money Market and the Slope of the Aggregate-Demand Curve

(1) A higher price level raises money demand,


(2) higher money demand leads to a higher interest rate,
(3) a higher interest rate reduces the quantity of goods and services demanded.
15-12
FIGURE 15.6
A Monetary Injection in a Closed Economy

15-13
HOW MONETARY POLICY
INFLUENCES AGGREGATE DEMAND
SUMMARY
 When the Bank of Canada increases the money supply, it
lowers the interest rate and increases the quantity of goods and
services demanded for any given price level, shifting the
aggregate-demand curve to the right.
 Similarly, when the Bank of Canada contracts the money
supply, it raises the interest rate and reduces the quantity of
goods and services demanded for any given price level,
shifting the aggregate-demand curve to the left.
15-14
HOW MONETARY POLICY
INFLUENCES AGGREGATE DEMAND
OPEN-ECONOMY CONSIDERATIONS
 Canadian economy is described as a small open economy
with perfect capital mobility
 Which implies that Canada’s interest rate must move up
and down with changes in the world interest rate
 How does a monetary injection affect the aggregate-
demand curve in a small open economy?

15-15
FIGURE 15.7
A Monetary Injection in a Small Open Economy

15-16
TABLE 15.1
The Effects of a Monetary Injection: Summary

15-17
PRACTICE PROBLEM 1
 Explain how each of the following developments would affect the supply of money, the demand for
money, and the interest rate. For each case, show what happens in a closed economy and in a small
open economy. Illustrate your answers with diagrams.
a. The Bank of Canada’s bond traders buy bonds in open-market operations.
b. An increase in credit card availability reduces the cash people hold.

15-18

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