Monetary Policy and Aggregate Demand: Short-Run in Open and Closed Economies

15-1 How Monetary Policy Influences Aggregate Demand

• Learning objectives for the chapter

  • Learn the theory of liquidity preference as a short-run theory of the interest rate
  • Analyze how monetary policy affects interest rates and aggregate demand in open and closed economies
  • Understand how the choice of exchange rate policy limits or strengthens monetary policy actions
  • Discuss the debate over whether central banks should try to stabilize the economy

• Scenario framing (Page 1)

  • Imagine you are the governor of the Bank of Canada determining monetary policy during a slowdown with rising unemployment
  • The chapter asks how monetary policy influences the economy and how policy choices affect the position of the aggregate-demand (AD) curve in the short run
  • Review of prior chapters: AD-AS in the short run, fiscal policy in Chapters 16, long-run effects discussed in Chapters 7–13, and the focus now on short-run policy effects
  • Outline of approach: first analyze policy effects in a closed economy, then extend to a small open economy (Canada) to see how openness matters

• Chapter structure in context (Page 1)

  • The effect of monetary and fiscal policy on AD depends on how open the economy is to trade in goods, services, and financial capital
  • Step-by-step approach: start with a closed economy, then discuss implications for a small open economy

• Why monetary policy matters for AD (Page 2)

  • Aggregate-demand (AD) = total quantity of goods/services demanded at each price level
  • AD slopes downward for three reasons:
  • Wealth effect: lower price level increases real wealth, boosting consumption
  • Interest-rate effect: lower price level lowers the interest rate as people lend excess money; stimulates investment
  • Real exchange-rate (RER) effect: lower price level reduces the real exchange rate, making Canadian goods cheaper relative to foreigners; net exports rise
  • Not all three are equally important:
  • In a closed economy, the RER effect is nonexistent; the interest-rate effect is the main driver of the downward slope
  • In a small open economy (like Canada), the RER effect becomes important due to exports/imports
  • In Canada, exports/imports are a large share of the economy, so the RER effect is a key explanation for the downward slope of AD

• The Theory of Liquidity Preference (15-1a) (Page 3)

  • Keynes’ liquidity preference theory explains how the economy’s interest rate is determined by the balance of money supply and money demand
  • Two interest rates: nominal rate (i) and real rate (r)
  • When there is no inflation, nominal and real rates are the same; with expected inflation, nominal rate > real rate by the expected inflation rate
  • We consider changes in the interest rate with a fixed expected inflation rate (short run)
  • Money supply (Ms): controlled by the Bank of Canada (BoC)
  • BoC primarily uses two tools to alter Ms:
    • Bank rate: the rate at which BoC lends to commercial banks; higher bank rate reduces reserves and reduces Ms; lower bank rate increases reserves and increases Ms
    • Open-market operations (OMO): BoC buys/sells government bonds; purchases increase bank reserves and Ms; sales reduce reserves and Ms
    • BoC can also conduct foreign-exchange market operations (FX operations), which can also affect Ms
  • Open-market purchases of foreign currency increase the domestic money supply by the amount of foreign currency purchased (in CAD), while FX sales reduce the money supply
  • For policy analysis in this chapter, we can simplify by assuming the BoC controls the money supply directly (Ms fixed at a chosen level)
  • Money supply is illustrated as a vertical supply curve in the money market diagram: the quantity of money supplied is fixed and does not depend on the interest rate
  • Money demand (Md): depends on the interest rate, price level, and real GDP
  • Liquidity preference: money is the most liquid asset; its demand is inversely related to the opportunity cost of holding money (the interest rate)
  • Md is downward-sloping in the interest rate: higher i raises the opportunity cost of holding money and reduces Md
  • Md also depends positively on the value of transactions: higher price level or higher real GDP increases the dollar value of transactions, raising Md
  • Equilibrium in the money market occurs where money supply equals money demand: $M^s = M^d(r)$
  • Shifts in Md occur with changes in P or Y (real GDP)
  • Higher P or higher Y shifts Md to the right (Md1 → Md2), raising the equilibrium interest rate if Ms is fixed
  • Figure references (for understanding):
  • Money market equilibrium with fixed Ms and Md(r, P, Y)
  • Shifts in Md due to price level or real GDP changes

• The Downward Slope of the AD Curve (15-1b) (Pages 8–11)

  • Using liquidity preference to re-derive the AD downward slope
  • If the overall price level rises, Md increases for any given r, pushing the money market to a higher r (since Ms is fixed)
  • Higher r raises the cost of borrowing and reduces investment and durable-goods spending, lowering aggregate demand
  • Process summarized in three steps (for a higher price level):
  • (1) Higher price level raises Md
  • (2) Higher Md raises the interest rate
  • (3) Higher interest rate reduces investment/durables, lowering AD
  • In an open economy, the RER effect adds another channel: higher price level raises the real exchange rate, making Canadian goods more expensive abroad, reducing NX; NX falls, reinforcing the downward AD slope
  • In a small open economy, both the interest-rate channel and the RER channel contribute to the downward slope of AD

• Changes in the Money Supply (15-1c) (Pages 11–13)

  • Monetary policy can shift the AD curve by changing the money stock
  • In a closed economy (no international capital flows):
  • An increase in Ms lowers the equilibrium interest rate (r falls) and increases AD (shift AD1 → AD2)
  • The fall in r increases investment and consumption of durable goods; money demand rises (Md1 → Md2), partially offsetting the fall in r
  • Net effect: AD shifts to the right; price level assumed fixed in the short run, so output/pattern moves along AD
  • Summary for a closed economy: Higher Ms → lower r → higher AD (AD shifts right)
  • In a small open economy (with perfect capital mobility):
  • World interest rate rw constrains domestic rates: in the short run, domestic rate tends to equal rw (r = rw)
  • Start from r = rw; an expansionary monetary shock would push domestic rate below rw if the exchange rate is flexible
  • Domestic residents would invest more domestically at lower rate, but capital flows cause: (i) depreciation of the domestic currency, (ii) an increase in NX due to cheaper domestic goods in world market
  • The process in the open economy with flexible exchange rates:
    • Monetary injection shifts the domestic money-supply curve (MS) to the right (MS1 → MS2); r falls below rw to r2, to balance new Ms with Md (while leaving Md unchanged initially)
    • Lower r stimulates investment and durable goods spending; output rises (Y1 → Y2), which increases Md2 → Md3; the interest rate then rises toward rw (r3)
    • Net AD effect is to shift AD from AD1 to AD2; however, because domestic rate is still below rw, capital flows push the exchange rate down (depreciation) and NX rises further, shifting AD again from AD2 to AD3
    • The end result: in a small open economy with flexible exchange rates, a monetary injection shifts AD farther to the right than in a closed economy (AD1 → AD3), and output increases to Y3
  • Summary for open economy with flexible exchange rate: a monetary injection lowers domestic interest rate, depreciates the currency, raises NX, and shifts AD more to the right than in a closed economy
  • Fixed exchange-rate case: limiting depreciation means the BoC must intervene in the foreign-exchange market to keep the currency from depreciating, which involves selling foreign currency and buying CAD, reducing the money supply and offsetting the expansionary monetary impulse; thus, the AD shift is smaller or may be negated

• Open-Economy Considerations (15-1d) (Pages 13–17)

  • Recap: Canada as a small open economy with perfect capital mobility implies domestic interest rates align with world rates in the long run
  • Under flexible exchange rates, a monetary injection leads to: (i) lower domestic r, (ii) depreciation of the CAD, (iii) higher NX, (iv) AD shifts more to the right than in a closed economy
  • Under fixed exchange rates, BoC actions to expand the money supply would tend to depreciate the CAD, which would force BoC intervention to maintain the peg, effectively reversing the monetary expansion; the policy would not be as effective in stimulating AD
  • Table 15.1 (summary of effects):
  • How a monetary injection shifts the AD curve in a closed economy: Ms ↑ → r ↓ → I, C ↑ → AD ↑; MD shifts up modestly; AD shifts right
  • How a monetary injection shifts the AD curve in an open economy (ignoring tax/difficulty differences): initial r = rw; Ms ↑ → r ↓ below rw → domestic assets become less attractive → capital flows → exchange-rate depreciation → NX ↑ → AD shifts further right; eventually r returns to rw
  • FYI: The Zero Lower Bound (ZLB)
  • If target interest rate hits zero, conventional monetary policy becomes less effective; liquidity trap concerns arise
  • Solutions include raising inflation expectations to reduce real rates, or using unconventional tools like quantitative easing (QE) and expanding the set of assets purchased (e.g., mortgages, corporate debt)
  • Acknowledges that some economists favor higher target inflation to provide room to ease in a downturn

• The Zero Lower Bound and Unconventional Tools (Page 20–21)

  • Liquidity trap: when nominal rates are at or near zero, additional monetary expansion may only increase liquidity without lowering real rates further
  • Central banks’ options beyond conventional policy:
  • Raise inflation expectations via commitment to future monetary expansion
  • QE: purchase a broader set of assets toLower long-term rates (evidence from the U.S. during 2008–09) and BoC’s stated willingness to use QE if necessary
  • Inflation targeting around zero has trade-offs: higher inflation allows negative real rates and more policy space during downturns
  • The key policy takeaway: if BoC wants to affect real activity through monetary policy, it generally needs to allow exchange-rate flexibility; trying to keep the currency fixed while expanding money supply reduces policy effectiveness

• Quick Quiz (Quickly testing understanding)

  • Explain how a decrease in the money supply affects the money market and the position of the AD curve; differences in a closed vs. open economy

• Case study: Central Banks and Stock Markets (Page 21–22)

  • Stock prices influence aggregate demand via wealth effects and investment incentives
  • Central banks do not target stock prices directly but monitor the economy and act to stabilize aggregate demand; higher stock prices can stimulate AD, while a stock market crash can depress AD
  • The interaction goes both ways: monetary policy affects stock prices and stock prices influence expectations and spending

• 15-2 Using Monetary Policy to Stabilize the Economy (Page 23–25)

  • The Case for Active Monetary Stabilization Policy (15-2a)
  • Economies are subject to unexpected events (energy price spikes, exchange-rate fluctuations, stock-market swings) that affect output, unemployment, and inflation
  • With a flexible exchange rate, monetary policy can move the AD curve and stabilize the economy by offsetting developments that push AD left or right
  • The Case against Active Monetary Stabilization Policy (15-2b)
  • Critics argue policy has long lags: many investment decisions are planned far in advance, so policy effects can take six months or more to impact output and employment, and can last for years
  • Forecasting errors and uncertainty make fine-tuning the economy risky; some advocate a passive approach (slow, steady growth in the money supply) instead of frequent fine-tuning
  • The Flexible Exchange Rate as a Stabilizer (15-2c)
  • Flexible exchange rates can insulate the economy from foreign shocks to exports/imports
  • Example: a U.S. recession reduces Canadian net exports; with flexible FX, the CAD depreciates, NX rises, and AD shifts back to the right; the world interest-rate alignment restores equilibrium
  • Trade-offs: flexible FX introduces price uncertainty for exporters/importers; some propose a monetary union (e.g., USD) to avoid this uncertainty, but most economists currently favor flexible FX due to benefits outweighing the costs

• 15-3 A Quick Summary (Page 26–29)

  • The chapter shows how monetary policy affects the AD curve in both closed and open economies under fixed and flexible exchange rates
  • Key controlling assumptions: price level is relatively sticky in the short run; we model the economy with short-run stickiness to analyze policy effects
  • Short-run vs long-run relationships summarized:
  • Long-run determinants (classical): output depends on capital, labor, and technology; prices adjust to money supply; monetary policy shifts price level but not real output in the long run
  • Short-run determinants (Keynesian): prices are sticky; the interest rate adjusts to balance money supply and demand; changes in r affect AD
  • In a closed economy, the interest rate adjusts to balance the money market; AD responds through the interest-rate channel
  • In a small open economy, the domestic rate must align with the world rate; with a flexible exchange rate, changes in the exchange rate modify NX and AD; with a fixed exchange rate, the BoC must intervene in the FX market which affects the money supply
  • The overall framework ties together three main macro relationships: the money market, the FX market, and the AD curve
  • Figure 15.8 (summary diagram) shows how monetary policy shifts AD differently depending on openness and exchange-rate regime

• 15-4 Conclusion (Pages 30–31)

  • Policymakers must consider all the effects of policy changes; prior classical models focused on long-run effects; this chapter emphasized short-run effects on AD, output, and employment
  • When the BoC lowers the growth rate of the money supply, it has to weigh long-run inflation consequences against short-run production effects
  • The next chapter will discuss fiscal policy's role in shifting AD and how fiscal and monetary policy should be coordinated for consistency

• Connections to broader themes (synthesis)

  • The three channels that make AD downward-sloping (wealth, interest-rate, real exchange-rate) operate in tandem; their relative importance shifts with openness and policy choices
  • In a small open economy, capital mobility links domestic monetary conditions to world rates; exchange-rate regime (flexible vs fixed) crucially shapes the transmission mechanism of monetary policy
  • Policy debates hinge on lags, uncertainty, and the trade-offs between stabilizing short-run fluctuations and preserving long-run goals like price stability and growth

• Key formulas and concepts to remember

  • Money market equilibrium: $M^s = M^d(r)$
  • Money supply: monetary policy can fix or change the money supply via mechanisms like the bank rate and open-market/FX operations
  • Money-demand function: $M^d = f(P, ext{Y}, r)$ where higher $P$ (price level) or higher real GDP $Y$ increase Md; higher $r$ lowers Md
  • Effect of a price level change on AD: higher price level raises Md → higher $r$ (if Ms fixed) → reduces investment and net exports → lower AD
  • In a small open economy with flexible exchange rates: r
    ightarrow r_w in the long run; monetary injections can cause currency depreciation, raising NX and shifting AD right further
  • In a fixed exchange-rate regime: maintaining the peg may require contracting the money supply to offset monetary expansion, muting the AD effect

• Practical implications (summary takeaways)

  • Monetary policy is a powerful short-run tool to stabilize AD, but its effectiveness depends on openness and exchange-rate regime
  • Flexible exchange rates enhance policy effectiveness by allowing automatic stabilizers via currency movements and NX; fixed regimes dampen or negate some stimulus effects
  • In zero lower bound scenarios, central banks can rely on unconventional tools (QE, broader asset purchases) and on policy communication to influence inflation expectations
  • The interaction between monetary policy and financial regulation matters: sound regulation can bolster policy effectiveness (as seen in the 2007–09 case study of Canada)

• Case-study takeaway (Monetary Policy Response to the 2007–09 Recession)

  • In a small open economy, expansionary monetary policy with a flexible exchange rate was effective in offsetting leftward shifts in AD
  • Canada benefited from a well-regulated financial sector and used conventional monetary policy rather than heavy QE, while coordinating with global central banks
  • The experience illustrates the practical importance of policy levers working in concert and the value of exchange-rate flexibility as a stabilizer

• Final note

  • The model is a simplification; future chapters may relax some assumptions to explore richer dynamics, but the core intuition remains: monetary policy shifts money supply, influences interest rates, moves AD, and the transmission mechanism is shaped by exchange-rate regimes and openness