Chapter 32Influence of Monetary & Fiscal Policy on Aggregate Demand

How Monetary Policy Influences Aggregate Demand

• Remember: AD slopes downward b/c of wealth effect, interest rate effect & exchange rate effect

• All 3 effects occur simultaneously, but interest rate effect is most important

Theory of Liquidity Preference

• Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance- we assume nominal & real interest rates move together

Money Supply

• Is controlled by Federal Reserve• Because Fed controls it w/o regard to other

econ. Variables; it’s represented with vertical supply curve

Money Demand

• Liquidity – how easy asset can be converted into medium of exchange ($ is most liquid)

• As interest rate rises, the quantity of money demanded falls – downward sloping demand

• Interest rate adjusts to bring money demand and money supply into balance

Downward Slope of AD Curve

• When PL increases, people demand more $, this shifts money demand curve to the right

• With fixed money supply, interest rate must rise

• With higher interest rate, return on saving increase so consumers more likely to save and less likely to invest in new housing

• Therefore, Q of goods & services will fall; basically explaining interest rate effect

Changes in Money Supply

• Fed buys bonds in open market operations – will increase supply of money; shifts money supply to right, interest rate falls & AD shifts right

Interest Rate Targets

• Monetary policy can be described either in terms of the money supply or the interest rate

• Fed sometimes targets a specific federal funds rate (interest rate for banks) rather than a certain money supply

The Fed & The Stock Market

• Fed will try to stabilize economy by lowering interest rates when stock market is down and by raising interest rates when stock market is soaring

Fiscal Policy & Aggregate Demand

• By changing taxing & spending, it shifts AD directly

• How much a change in gov’t purchases increases AD is based on Multiplier effect & Crowding Out effect

Fiscal Policy Influences Aggregate Demand• Primary effect of fiscal policy in the short run is on

AD• If Fed changes money supply, they influence

spending decisions of firms and households and thereby INDIRECTLY affect AD

• If Govt. changes tax rates, they influence the spending decisions of firms and households and thereby INDIRECTLY affect AD

• If Govt. changes its own spending, it DIRECTLY affects AD

If the Govt. increases spending by $20 billion dollars, how far does AD shift? To what extent does GDP increase?

The Multiplier Effect suggests that …….

The shift in AD could be larger than the change in Govt. spending (larger than $20 b)

G buys $20 from Boeing

Boeing increases employment/income

Increase Consumer Spending/Electronics

Electronics Industry. hires more

Increase ConsumerSpending

GDP +$20

Spending Multiplier• MPC• Fraction of extra income that a household

consumes rather than saves• If MPC = .80…..it means that…….• For every extra dollar of income the

household earns, the household will spend 0.80…and save 0.20

• If MPC is 0.80, then MPS is …..• 0.20• If Govt. spends $20b…then that is extra income for

Boeing and they will spend…….• $16 b and save $4b…..• and that spending is an extra $16b income for

others, of that they will spend…..• $12.8 b and save $3.2 b…….• And that spending is an extra $12.8b income for

others, of that they will spend…..• $10.24 b and save $2.56b…..and so on and on….

• So the multiplier is 1 / (1-MPC) …. or ….• 1/MPS • ……so the original $20 b of increased govt.

spending could generate a total of ……• $100 b ……..how? • $20 b initial increase x 1/.20 ….• $20 b x 5 = $100 b• COULD?????? Why the word “could” ?• The larger the MPC, …the …..• Larger the Multiplier……..Explain

Changes in Taxes

• Affects AD like spending except, indirectly so therefore you have to look at MPC & MPS closely

• Also impacted by multiplier & crowding out effects

• If tax cuts/increases are seen as permanent, it has larger impact than temporary ones

Crowding Out Effect

• If gov’t uses fiscal policy to expand (lowers taxes, increases spending) it will have multiplier effect on AD, but it also will cause interest rate to rise

• This rise in interest rate will decrease investment, which lowers AD thereby “crowding out” some of the growth (gov’t spending crowds out investment spending)

Crowding Out