Influence of Monetary and Fiscal Policy on Aggregate Demand

Chapter 21: The Influence of Monetary and Fiscal Policy on Aggregate Demand

Introduction

  • Earlier chapters discussed:

    • Long-run effects of fiscal policy on:

    • Interest rates

    • Investment

    • Economic growth

    • Long-run effects of monetary policy on:

    • Price level

    • Inflation rate

  • Current chapter focuses on:

    • Short-run effects of fiscal and monetary policy through aggregate demand (AD)

Chapter Objectives

By the end of the chapter, you should be able to answer:

  • 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?

21-1 How Monetary Policy Influences Aggregate Demand

  • The AD curve slopes downward due to three primary reasons:

    • The Wealth Effect:

    • When price level (P) decreases, real wealth increases, leading to an increase in aggregate demand (AD).

    • The Interest Rate Effect:

    • When P decreases, interest rates decrease, leading to an increase in investment (I) and AD.

    • The Exchange Rate Effect:

    • When P decreases, real interest rates affect net capital outflows (NCO), which alters the supply of the dollar, impacting exchange rates and net exports (NX), subsequently increasing AD.

Theory of Liquidity Preference

  • Liquidity Preference Theory: A basic theory explaining the interest rate (r) as it balances money supply and money demand.

    • Nominal vs Real Interest Rate:

    • Nominal interest rate is the stated rate, while real interest rate adjusts for inflation.

    • Assumption: Expected rate of inflation stays constant.

  • Money Supply (MS):

    • Assumed fixed by the central bank; not influenced by interest rates.

    • The Federal Reserve (Fed) alters MS through:

    • Open market operations

    • Changing reserve requirements

    • Adjusting the interest rate on reserves

    • Changing the discount rate

Money Demand

  • Money Demand Variables: Influenced by

    • Real income (Y)

    • Interest rate (r)

    • Price level (P)

  • Effects on Money Demand:

    • When Y rises, demand for money increases as households want to purchase more goods.

    • If r rises (holding Y and P constant), money demand decreases as households seek to buy bonds instead (opportunity cost).

    • If P rises (holding Y and r constant), money demand increases as households need more money for the same amount of goods.

How r Is Determined

  • The MS curve is vertical: changes in r do not affect MS, fixed by the Fed.

  • The MD curve is downward sloping: a fall in r increases money demand.

The Interest-Rate Effect Mechanism

  • Lower P reduces money demand, leading to lower r.

  • A lower r increases investment and the quantity of goods/services demanded.

Monetary Policy Impacts on Aggregate Demand

  • The Fed uses monetary policy to shift AD curves with the goal of stabilizing output.

  • Increasing MS lowers r and raises quantity demanded, shifting AD right; vice versa for contracting MS.

Active Learning Scenarios

  1. Congress cuts government spending:

    • Decreases AD and output; Fed should increase MS and decrease r to stabilize.

  2. Stock market boom increases wealth:

    • Increases AD, Fed should decrease MS and increase r.

  3. War causes oil prices to soar:

    • Decreases aggregate supply, Fed should increase MS and decrease r.

The Zero Lower Bound (ZLB)

  • In a liquidity trap, if r approaches zero, monetary policy becomes ineffective.

  • Justifies higher target inflation rates to provide room for stimulating the economy when needed.

  • Alternatives after reaching the ZLB:

    • Forward Guidance: Encouraging inflation expectations by committing to low interest rates.

    • Quantitative Easing: Buying a broader range of financial instruments to expand the economy.

21-2 How Fiscal Policy Influences Aggregate Demand
Fiscal Policy Definition

  • Fiscal Policy is the government’s approach to setting levels of spending and taxation.

    • Expansionary Fiscal Policy:

    • Increase in government spending (G) and/or decrease in taxes (T) shift AD right.

    • Contractionary Fiscal Policy:

    • Decrease in G and/or increase in T shifts AD left.

Changes in Government Purchases

  • Altering government purchases directly shifts AD.

  • Multifactor Effects:

    • Multiplier Effect: The incrementally larger shifts in AD occur when fiscal policy increases income, stimulating consumption.

    • Crowding-Out Effect: Reduced AD occurs when expansionary fiscal policy raises interest rates, thereby logically reducing investment spending.

The Multiplier Effect Explained

  • Example: A $20 billion government purchase leads to a direct increase in AD through increased revenue for firms like Boeing.

    • Further, consumption from the workers and owners benefits other sectors, perpetuating demand increases.

  • Multiplier Calculation:

    • Multiplier = $1/(1 - MPC), where MPC is the marginal propensity to consume.

    • E.g., if MPC = 0.8, then an increase in income leads to $80 increase in consumption for every $100 rise in income.

Crowding-Out Effect Explained

  • The increase in G shifts AD right initially, but higher output raises money demand and interest rates, reducing AD.

Tax Changes and Their Effects

  • Tax Cuts Increase Consumption:

    • Increase household disposable income, thus shifting AD rightward; influenced by perceptions of the permanence of tax changes.

21-3 Using Policy to Stabilize the Economy
Active Stabilization Policy

  • Proponents argue the government must respond to shifts in aggregate demand caused by irrational fluctuations in sentiment (animal spirits).

  • Keynesian perspective advocates for using expansionary policies when GDP falls below the natural rate and contractionary policies when it exceeds it.

Passive Policy Critique

  • Critics contend timing lags in monetary and fiscal policy diminish their stabilizing effects, citing potential destabilization if policy does not align with real economic conditions.

  • Focus is better placed on long-term economic growth and low inflation instead.

21-4 Conclusion

  • Policy instruments play direct roles in shaping aggregate demand while time horizons remain critical.

  • Long-run effects must always be weighed against short-run impacts in decision-making processes of Congress (G/T changes) and the Fed (money supply/interest rates).

  • Policymakers should maintain a balance between long-run and short-run economic goals.

Additional Activities

  • Discussion prompts and self-assessment scenarios are proposed to encourage application of concepts learned in real-world contexts.