Chapter 15 & 16

THE INFLUENCE OF
MONETARY AND
FISCAL POLICIES ON
AGGREGATE DEMAND
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 LEARNING OUTCOME

Employ the Aggregate Demand- Aggregate Supply

model to analyze the impact of changes in
macroeconomic variables on the equilibrium price level
and GDP and to analyze the impact of monetary, fiscal
and trade policies.

15-2
 Learning Objectives

• Explain the Theory of Liquidity Preference as a short run

theory of interest rate.
• Analyze how Monetary Policy affects interest rates and
Aggregate Demand in closed and open economies.
• Understand how the choice of exchange rate policy limits or
strengthens monetary policy actions.
• Analyze how Fiscal Policy affects interest rates and Aggregate
Demand in closed and open economies.
• Understand how the choice of exchange rate policy limits or
strengthens the fiscal policy actions.
• Discuss the debate over the issue of active stabilization

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How Monetary Policy Influences Aggregate
Demand
• The aggregate-demand curve slopes downward for three reasons:
1. The wealth effect (lower p >> raises money holding >> raise con spending)
2. The interest-rate effect (lower interest rate>> more investment spending)
3. The real exchange–rate effect (reduce RER >> cheaper >> NX rise)
• The interest-rate effect is the most important reason for the downward slope
of the aggregate-demand curve.

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How Monetary Policy Influences Aggregate
Demand THE THEORY OF LIQUIDITY PREFERENCE
• The theory of liquidity preference is Keynes’s theory stating that the interest rate adjusts
to bring money supply and money demand into balance.
• In the analysis that follows, the expected rate of inflation is held constant.
• 2 methods foe theory : money supply, money demand
• The Bank of Canada alters the money supply using two methods(money supply):
1. Changing the overnight rate (increase interest >> reduces the money supply)
2. Open-market operations
• Buying and selling federal government bonds
• Foreign exchange market operations
Þ Changes in reserved >> changes in ability to make loans and create money
Þ BOC buys giv bonds >> reserve falls
Nominal interest is interest usually reported, rel interest is corrected for the effects of
15-5
inflation. Thereis no inflation >> 2 interest the same
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Figure 15.4: Equilibrium in the Money Market
Downwards:
Interest rate
reduces the Q of
money demanded
• Although many factors determine
the quantity of money demanded,
the one emphasized by the theory
of liquidity preference is the
interest rate.
• Interest rate is the opportunity cost
of holding money. An increase in
interest rate, increases the
opportunity cost, hence people
hold less money at higher interest
rate and vice versa.
• If the dollar value of transactions increases because of an increase in Price level or
real GDP, people will hold more money at any interest rate. It causes a shift in
money demand. 15-6
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Increase in interest rate raises the cost of holding money (liquidilty) >> reduces
the quantity of money demanded
• Interest rate is the OC of holding money (u lose the interest rate u’ve eanred if
holding money)
• The decrease in interest rate reduces the cost of holding money and raises the
quantity demanded
• Thde decrease in the dollar value of transactions causes the demand for money
to decrease

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th

be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Figure 15.5: The Money Market and the Slope of
the Aggregate-Demand Curve
Increase in P => Money demand
increase => interest rate in >> de I >>
de AD along the curve
Interest rate is the cost of borrowing,
increase in interest rate >> redcues the
quantity of good and services
demanded

• An increase in price level from P1 to P2 increases money demand in (a).

• This increase in money demand causes the interest rate to rise from r 1 to r2.
• The increase in the interest rate reduces the quantity of goods and services demanded from Y1 to
Y2. (through investment component of AD). 15-8
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 Figure 15.6: Monetary Policy Effect in a Closed Economy

• In panel (a), an increase in the money supply from MS1 to MS2 reduces the equilibrium interest rate from r1 to r2.
• Fall in interest rate raises the quantity of goods and services demanded at a given price level. At the same time, the
increase in output requires that people hold more money. This causes the demand for money to increase from MD1
to MD2 and causes a partial reversal in the interest rate, from r2 to r3.
• As a result, the increase in the quantity demanded of goods and services is smaller than it would otherwise have
been. Hence, the aggregate-demand curve shifts to the right from AD1 to AD2, and we move from point A to point B
in panels (a) and (b). 15-9
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Figure 15.7: Monetary Policy Effect in a Small Open
Economy Raises until r Canada = r world

• In a closed economy, increase in Ms causes interest rate to fall, investment to increase and output to
increase. (A to B in both graphs above)
• In SOE, r3 < rw, foreign assets will be more attractive, NCO increases, real exchange rate decreases,
NX increases, AD increases from AD2 to AD3. This causes people to hold more money, MD shifts to
15-10
MD3 and r=rW
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How Monetary Policy Influences Aggregate
Demand
• Flexible exchange rate is a policy by which the value of the exchange rate
is allowed to vary without interference by the central bank.
• In a small open economy with a flexible exchange rate, a monetary injection
causes the dollar to depreciate in value.
• This causes an increase in the demand for Canadian-produced goods and
services that is not realized in a closed economy.
• In the end, the aggregate-demand curve shifts farther to the right than it does
in a closed economy.
• Fixed exchange rate is a policy by which the value of the exchange rate is
held fixed by the central bank.

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Table 15.1: The Effects of a Monetary Injection:
Summary
the increase in the amount of money circulating in the economy, which then
How Does a Monetary Injection(
increases the amount of funds available to financial intermediaries to be loaned out at lower interest rates.) Shift
the Aggregate-Demand Curve in a Closed Economy?
1. An increase in money supply causes the interest rate to fall.
2. The fall in the interest rate stimulates investment and consumption of durable goods. The increase in spending increases the
demand for money, causing a partial reversal of the fall in the interest rate.
3. The increase in spending shifts the aggregate-demand curve to the right.
How Does a Monetary Injection Shift the Aggregate-Demand Curve in an Open Economy?
1. Due to perfect capital mobility, and ignoring differences in default risk and taxes, Canada's interest rate must equal the world
interest rate. We begin with r = r w.
2. An increase in the money supply causes Canada's interest rate to fall below r w.
3. The fall in the interest rate stimulates investment and consumption of durable goods. The increase in spending increases the
demand for money, causing a partial reversal of the fall in the interest rate. Canada's interest rate remains below r w.
4. With r < rw, Canadian assets are sold in favour of buying foreign assets. The switch from Canadian to foreign assets requires that
dollars be sold in the market for foreign currency exchange. The real exchange rate falls.
5. The fall in the real exchange rate increases net exports, causing the aggregate demand curve to shift even farther to the right.
6. This additional stimulus to spending increases the demand for money until r = r w.
7. It makes sense for the Bank of Canada to cause a monetary injection only if it allows the exchange rate to be flexible.
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Using Monetary Policy to Stabilize the Economy
ACTIVE MONETARY STABILIZATION POLICY
• Monetary policy can affect the economy’s aggregate demand for goods
and services.
• This raises some important policy questions: Should the central bank use
this instrument to control aggregate demand and stabilize the economy?
• For: If monetary policy can stabilize the economy, then it should be used to
offset the harmful effects of economic fluctuations on firms and people.

• Against: Monetary policy affects the economy with a long lag.

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Using Monetary Policy to Stabilize the Economy

THE FLEXIBLE EXCHANGE RATE AS A STABILIZER

• Allowing the exchange rate to be flexible enables policymakers to insulate

the Canadian economy from the effects of foreign recessions and restrictive
trade policies imposed by our trading partners.
• An important cost is the uncertainty that a flexible exchange rate introduces
into the pricing decisions of exporting and importing firms.
• The majority of economists today are of the view that the benefits associated
with choosing a flexible exchange rate exceed the costs.

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How Fiscal Policy Influences Aggregate
Demand
CHANGES IN GOVERNMENT PURCHASES

• When the government alters its own purchases of goods and services, it
shifts the aggregate-demand curve directly.
• Two macroeconomic effects make the size of the shift in aggregate demand
differ from the change in government purchases:
1. The multiplier effect
2. The crowding-out effect
*changes in gov pruchases: shift the AD curve by influencing the spen ding
decisions of firms/ househols >> shift the curve directly

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FIGURE 16.1: The Multiplier Effect
• Multiplier effect is the additional
shifts in aggregate demand that
result when expansionary fiscal
policy increases income and
thereby increases consumer
spending. (1 dollar spend by the
gov >> can raise more than 1
dollar of demand of
goods/services)
• This multiplier effect can be
strengthened by the response of
investment to higher levels of
demand.
• This positive feedback from
demand to investment is
sometimes called the investment
accelerator. 15-16
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How Fiscal Policy Influences Aggregate
Demand
A FORMULA FOR THE SPENDING MULTIPLIER
• Marginal propensity to consume (MPC) is the fraction of extra income
that a household consumes rather than saves.
• For example, suppose that the marginal propensity to consume is ¾.
• This positive feedback from demand to investment is sometimes called the
investment accelerator.
• With an MPC of ¾, when the workers and owners of the construction firms earn
$5 billion from the government contract, they increase their consumer spending
by ¾ × $5 billion, or $3.75 billion.

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How Fiscal Policy Influences Aggregate Demand

Change in GVT purchase = × $5 billion

First change in consumption = MPC × $5 billion
First change in consumption = MPC2 × $5 billion
First change in consumption = MPC3 × $5 billion
. .
. .
. .
Total change in demand = (1 + MPC MPC2 + MPC3 + ...) × $5 billion

Multiplier  1  MPC  MPC 2  MPC3  

In a closed economy: Multiplier = 1 / (1 − MPC)
In an open economy: Multiplier = 1 / (1 − MPC + MPI) 15-18
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FIGURE 16.2: The Crowding-Out
Open economy
Effect on
Investment (fiscal)
R2>rw => de NCO

Crowding-out effect on investment is the offset in aggregate demand that results when
expansionary fiscal policy raises the interest rate and thereby reduces investment spending.
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FIGURE 16.3: A Fiscal Expansion in a Small Open
Economy with a Flexible Exchange Rate

Crowding-out effect on net exports: In a SOE, an expansionary fiscal policy causes the dollar to
appreciate, which leads to a fall in NX that reduces AD further. Fiscal policy has no lasting effect on
aggregate demand under flexible exchange rate system.
15-20
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 FIGURE 16.4: A Fiscal Expansion in a Small Open
Economy with a Fixed Exchange Rate Fiscal Policy has
larger effect with
fixed exchange
rates;
Monetary
Policy has larger
effect with
flexible exchange
rate

• If the Bank of Canada chooses to prevent any change in the exchange rate, expansionary fiscal policy will have no
crowding-out effects and will therefore cause a very large increase in the demand for goods and services.
• For fiscal policy to have a lasting effect on the position of the aggregate-demand curve, the Bank of Canada must
choose the appropriate exchange-rate policy.
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TABLE 16.1: The Effects of Fiscal Policy: Summary
How Does Fiscal Policy Shift the Aggregate-Demand Curve in a Closed Economy?
1. An increase in government spending shifts the aggregate-demand curve to the right.
2. Increased spending increases money demand, and this increases the interest rate.
3. The rise in the interest rate crowds out investment and reduces somewhat the size of the shift in the aggregate-demand curve.

How Does Fiscal Policy Shift the Aggregate-Demand Curve in a Small Open Economy with a Flexible Exchange Rate?

1. Due to perfect capital mobility, and ignoring differences in default risk and taxes, Canada's interest rate must equal the world interest rate. We begin
with r = rw
2. An increase in government spending shifts the aggregate-demand curve to the right,
3. Increased spending increases money demand, and this increases the interest rate.
4. The rise in the interest rate crowds out investment and reduces somewhat the size of the shift in the aggregate-demand curve. Now r > r w.

5. Canadian assets now pay a higher interest rate than foreign assets. Increased 'demand for Canadian assets means an increased demand for dollars
in the market for foreign-currency exchange. The dollar appreciates.
6. The appreciation of the dollar reduces net exports.
7. The Fallin net exports means a Fallin spending, a Fallin money demand, and a Fallin interest rates until r = r w.
8. The increase in government spending has no lasting influence on the position of the aggregate-demand curve.

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TABLE 16.1: The Effects of Fiscal Policy:
Summary
How Does Fiscal Policy Shift the Aggregate-Demand Curve in a Small Open Economy with a Fixed Exchange Rate?
1. Due to perfect capital mobility, and ignoring differences in default risk and taxes, Canada's interest rate must equal the world
interest rate. We begin with r = rw.
2. An increase in government spending shifts the aggregate-demand curve to the right.
3. Increased spending increases money demand, and this increases the interest rate.
4. The rise in the interest rate crowds out investment and reduces somewhat the size of the shift in the aggregate-demand
curve. Now r > rw.
5. Canadian assets now pay a higher interest rate than foreign assets. Increased 'demand for Canadian assets means an
increased demand for dollars in the market for foreign-currency exchange. To fix the exchange rate, the Bank of Canada
increases the supply of dollars traded in the market for foreign-currency exchange by purchasing foreign currency.
6. The purchase of foreign currency by the Bank of Canada causes the money supply to increase, and this causes the interest
rate to fall until r = rw.
7. The increase in the money supply shifts the aggregate-demand curve even farther to the right.

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Using Fiscal Policy to Stabilize the Economy

THE CASE FOR ACTIVE FISCAL STABILIZATION POLICY

• Keynes emphasized the key role of aggregate demand in explaining short-

run economic fluctuations and that the government should actively stimulate
aggregate demand when aggregate demand appeared insufficient to
maintain production at its full-employment level.

15-24
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Using Fiscal Policy to Stabilize the Economy

THE CASE AGAINST ACTIVE FISCAL STABILIZATION POLICY

• The setting of tax rates and the design of spending programs ought to be
chosen to achieve long-run goals such as rapid economic growth and an
equitable distribution of income.
• The economy should be left to deal with short-run fluctuations on its own.
• Fiscal policies affect the economy with a long lag.
• By the time the change in fiscal policy is passed and ready to implement,
the condition of the economy may well have changed.
• What’s more, fiscal policy is open to political interference that may cause
efforts at economic stimulus to not be aimed to where it is in most need.
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Using Fiscal Policy to Stabilize the Economy

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.
• The tax system
• Government spending

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The Fiscal Policy Response to COVID-19

• The fiscal policy response was very large and very broad.
• Families:
• Supports for individuals and families in the form of income support measures for
those whose employment was impacted by the pandemic.
• Expanded sickness benefits to enable people to isolate should they show COVID
symptoms.
• Mortgage deferral programs.
• Caregiving benefit to support people unable to work due to needing to care for family
members needing to quarantine or made ill by the pandemic.

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The Fiscal Policy Response to COVID-19

• Businesses:
• Emergency access to financing, loan guarantees, and wage subsidies.
• Caregiving benefit to support people unable to work due to needing to care
for family members needing to quarantine or made ill by the pandemic.

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The Fiscal Policy Response to COVID-19

• Assuming no change in monetary policy, such a large fiscal response would

ordinarily cause crowding out of investment and net exports because of an
increase in the interest rate and a resulting appreciation of the exchange
rate.
• But in response to the pandemic the Bank of Canada introduced an
expansionary monetary policy that had the effect of keeping interest rates
low.
• In this way, the investment and exchange rate crowding out of an
expansionary fiscal policy was prevented and the conditions were
established for fiscal policy to be able to have a large effect on aggregate
demand.
• Were these measures in fact effective at increasing aggregate demand?
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The Fiscal Policy Response to COVID-19

• In October 2021, the Bank of Canada estimated that consumption spending, the
largest component of aggregate demand, would account for over half of the
economic growth expected during 2021.
• That this would be the case despite an unemployment rate that had increased by
8 percentage points in 2020 and that even by October 2021 remained 1.2
percentage points higher than observed prior to the pandemic, suggests these
measures had indeed contributed to preventing aggregate demand from falling

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Active Learning: Ending a recession

The economy is in recession. Shifting the AD curve rightward by $20b would

end the recession.

A. If MPC = 0.8 and there is no crowding out, how much should the
government increase G to end the recession?

B. If there is crowding out, will the government need to increase G more or less
than this amount?

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Active Learning: Answers

A. If MPC = 0.8 and there is no crowding out, how much should the
government increase G to end the recession?

B. If there is crowding out, will the government need to increase G more or less
than this amount?
Crowding out reduces the impact of G on AD.
To offset this, the government should increase G by a larger amount.
15-32
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THE END

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