Chap_32The Influence of Monetary and Fiscal Policy on Aggreg

The Influence of Monetary and Fiscal Policy on Aggregate DemandChapter 32

Aggregate Demand Many

factors influence aggregate demand besides monetary and fiscal policy. In particular, desired spending by households and business firms determines the overall demand for goods and services.

Aggregate Demand When

desired spending changes, aggregate demand shifts, causing short-run fluctuations in output and employment. Monetary and fiscal policy are sometimes used to offset those shifts and stabilize the economy.

How Monetary Policy Influences Aggregate Demand The aggregate demand curve

slopes downward for three reasons: The

wealth effect The interest-rate effect The exchange-rate effect

How Monetary Policy Influences Aggregate DemandFor the U.S. economy, the most important reason for the downward slope of the aggregate-demand curve is the interest-rate effect.

The Theory of Liquidity Preference Keynes

developed the theory of liquidity preference in order to explain what factors determine the economy’s interest rate. According to the theory, the interest rate adjusts to balance the supply and demand for money.

Money Supply The money supply is controlled by

the Fed through: Open-market

operations Changing the reserve requirements Changing the discount rate

Money Supply Because

it is fixed by the Fed, the quantity of money supplied does not depend on the interest rate. The fixed money supply is represented by a vertical supply curve.

Money Demand Money

demand is determined by several factors. According to the theory of liquidity preference, one of the most important factors is the interest rate.

Money DemandPeople choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services.

Money Demand The opportunity cost of holding money

is the interest that could be earned on interest-earning assets. An increase in the interest rate raises the opportunity cost of holding money. As a result, the quantity of money demanded is reduced.

Equilibrium in the Money Market According The

to the theory of liquidity preference:interest rate adjusts to balance the supply and demand for money. There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded equals the quantity of money supplied.

Equilibrium in the Money MarketAssume the following about the economy: The price level is stuck at some level. For any given price level, the interest rate adjusts to balance the supply and demand for money. The level of output responds to the aggregate demand for goods and services.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Equilibrium in the Money Market...Interest RateMoney supply

r1Equilibrium interest rate

r20d M1

Money demand Quantity fixed by the Fedd M2

Quantity of Money

The Downward Slo

pe of the Aggregate Demand Curve The price level is one determinant of the

quantity of money demanded. A higher price level increases the quantity of money demanded for any given interest rate. Higher money demand leads to a higher interest rate. The quantity of goods and services demanded falls.

The Downward Slope of the Aggregate Demand CurveThe end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded.

The Money Market and the Slope of the Aggregate Demand Curve...(a) The Money MarketInterest Rate

(b) The Aggregate Demand Curve

Money supply

Price Level

r2 r1

2. …increases the demand for money…

1. An increase in the price level…P2Aggregate demand

Money demand at price level P2, MD2

P1Money demand at price level P1, MD1

0

Quantity fixed by the Fed

Quantity of Money

0

Y2

3. …which increases the equilibrium equilibrium rate…

4. …which in turn reduces the quantity of goods and services demanded.

Y1 Quantity of Output

Changes in the Money Supply The Fed can shift the aggregate demand

curve when it changes monetary policy. An increase in the money supply shifts the money supply curve to the right. Without a change in the money demand curve, the interest rate falls. Falling interest rates increase the quantity of goods and services demanded.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

A Monetary Injection...(a) The Money Market Interest RateMoney supply, MS1

(b) The Aggregate-Demand Curve Price Level

MS2

1. When the Fed increases the money supply…

3. …which increases the quantity of goods and services demanded at a given price level.

P

r1 r2AD2Aggregate demand, AD1

0

2. …the equilibrium interest rate falls…

Quantity of Money

0

Y1

Y2

Quantity of Output

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 at any given price level, shifting aggregatedemand to the right. When the Fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at any given price level, shifting aggregatedemand 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. Changes in monetary policy can be viewed either in terms of a changing target for the interest rate or in terms of a change in the money supply. A target for the federal funds rate affects the money market equilibrium, which influences