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:
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.

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:
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:
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
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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