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.

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:

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

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

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