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

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

21.1: How Monetary Policy Influences Aggregate Demand

  • Influences (REVIEW FROM CHAPTER 20)
    • The wealth effect
    • The interest-rate effect
    • The exchange-rate effect

The Theory of Liquidity Preference:

  • Theory of liquidity preference- preference Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance

    • Money supply
    • Feds alters the money supply primarily by changing the quantity of reserves in the banking system through the purchase and sale of government bonds in open-market operations.
    • Money Demand
    • 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
    • Equilibrium in the Money Market
    • the quantity of money demanded exactly balances the quantity of money supplied.

    Money Market

    Money Market and Slope

The Downward Slope of the Aggregate-Demand Curve:

  • A lower price level reduces money demand, which leads to a lower interest rate, and this in turn increases the quantity of goods and services demanded

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 for any given price level, shifting the aggregate-demand curve to the right.

  • Conversely, when the Fed 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.

    Monetary Injection

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.

21.2: How Fiscal Policy Influences Aggregate Demand

Changes in Government Purchases:

  • Fiscal policy- the setting of the level of government spending and taxation by government policymakers
  • When policymakers change the money supply or the level of taxes
    • It shifts the aggregate-demand curve indirectly by influencing the spreading decisions of firms and households
  • When the government alters its own purchases of goods and services
    • It shifts the aggregate-demand curve directly

The Multiplier Effect:

  • Multiplier effect- the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending

    Multiplier Effect

A Formula for the Spending Multiplier:

  • Variables
    • MPC (marginal propensity to consume)
    • The faction of extra income that a household consumes rather than saves
  • MPC* (the change in government purchases)
  • Total change in demand = (1 + MPC + MPC2 + MPC3 + . . .) ×(change in government purchases).

Other Applications of the Multiplier Effect:

  • Multiplier effect applies to any component of GDP
    • Consumption
    • Investment
    • Government purchases
    • Net exports

The Crowding-Out Effect:

  • Crowding-out effect- the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduce. investment spending

    Crowding-Out Effect

Changes in Taxes:

  • When the government cuts personal income taxes, it increases households’ take-home pay
  • “Tax-cut” represented only a short-term loan from the government

21.3: Using Policy to Stabilize the Economy

The Case for Active Stabilization Policy:

  • “The use of policy instruments to stabilize aggregate demand and, as a result, production and employment”
  • The government can adjust its monetary and fiscal policy in response to those waves of optimism and pessimism
    • To stabilize the economy

The Case Against Active Stabilization Policy:

  • Some economists claim that these policy instruments should be set to achieve long-run goals
    • Such as rapid economic growth and low inflation

Automatic Stabilizers:

  • Automatic stabilizer- changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action

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