1、34The Influence of Monetary and Fiscal Policy on Aggregate DemandThe burning issue Theory of liquidity preference Keyness theory that the interest rate adjusts to bring money supply and money demand into balance.The Theory of Liquidity Preference Keynes developed the theory of liquidity preference i
2、n order to explain what factors determine the economys interest rate.According to the theory,the interest rate adjusts to balance the supply and demand for money.The overview The aggregate demand curve slopes downward for three reasons:The wealth effectThe interest-rate effectThe exchange-rate effec
3、tHow monetary policy influences aggregate demand?The overview For the U.S.economy,the most important reason for the downward slope of the aggregate-demand curve is the interest-rate effect.“Irrational exuberance.”-that was how Federal Reserve Chairman Alan Greenspan once described the booming stock
4、market of the late 1990s.The idea in tangibleWhy the Fed watches the stock market?A booming stock market expands the aggregate demand for goods and services.when the stock market booms,households become wealthier,and this increased wealth stimulates consumer spending.a rise in stock prices makes it
5、more attractive for firms to sell new shares of stock,and this stimulates investment spending.The opposite occurs when the stock market falls.spending on consumption and investment declines,depressing aggregate demand and pushing the economy towards recession.Figure 1 Equilibrium in the Money Market
6、Quantity ofMoneyInterestRate0MoneydemandQuantity fixedby the FedMoneysupplyr2M2dMdr1EquilibriuminterestrateCopyright 2004 South-WesternFigure 2 The Money Market and the Slope of the Aggregate-Demand CurveQuantityof MoneyQuantity fixedby the Fed0InterestRateMoney demand at price level P2,MD2 Money de
7、mand atprice level P,MD Moneysupply(a)The Money Market(b)The Aggregate-Demand Curve3.whichincreasesthe equilibriuminterestrate.2.increases thedemand for money.Quantityof Output0PriceLevelAggregatedemandP2Y2YP4.which in turn reduces the quantityof goods and services demanded.1.Anincreasein thepricele
8、vel.rr2Copyright 2004 South-WesternFigure 3 A Monetary InjectionMS2Moneysupply,MSAggregatedemand,ADYYPMoney demand at price level PAD2Quantityof Money0InterestRaterr2(a)The Money Market(b)The Aggregate-Demand CurveQuantityof Output0PriceLevel3.which increases the quantity of goods and services deman
9、ded at a given price level.2.theequilibriuminterest ratefalls.1.When the Fedincreases themoney supply.Copyright 2004 South-WesternThe close Aggregate Demand Many factors influence aggregate demand besides monetary and fiscal policy.In particular,desired spending by households and business firms dete
10、rmines 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.Contents How monetary policy
11、influences aggregate demand?-theory of liquidity preference -the Downward Slope of the Aggregate Demand Curve -changes in the money supply How fiscal policy influences aggregate demand?-changes in the government purchases -multiplier effect -crowding-out effect -changes in taxes Using policies to st
12、abilize the economy -automatic stabilizersHOW 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 For the U.S.economy,the most important reason for the downward slope of the aggre
13、gate-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 economys interest rate.According to the theory,the interest rate adjusts to balance the supply and demand for money.Mone
14、y Supply The money supply is controlled by the Fed through:Open-market operations Changing the reserve requirements Changing the discount rate 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
15、 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.People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and se
16、rvices.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 to the theory of
17、liquidity preference:The 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 Market Assume the following about the econo
18、my: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.Figure 1 Equilibrium in the Money MarketQuantity ofMoneyInterestRate0MoneydemandQuantit
19、y fixedby the FedMoneysupplyr2M2dMdr1EquilibriuminterestrateCopyright 2004 South-WesternThe Downward Slope 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.High
20、er money demand leads to a higher interest rate.The quantity of goods and services demanded falls.The Downward Slope of the Aggregate Demand Curve The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded.Figure 2 The Money Mar
21、ket and the Slope of the Aggregate-Demand CurveQuantityof MoneyQuantity fixedby the Fed0InterestRateMoney demand at price level P2,MD2 Money demand atprice level P,MD Moneysupply(a)The Money Market(b)The Aggregate-Demand Curve3.whichincreasesthe equilibriuminterestrate.2.increases thedemand for mone
22、y.Quantityof Output0PriceLevelAggregatedemandP2Y2YP4.which in turn reduces the quantityof goods and services demanded.1.Anincreasein thepricelevel.rr2Copyright 2004 South-WesternChanges in the Money Supply The Fed can shift the aggregate demand curve when it changes monetary policy.An increase in th
23、e 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.Figure 3 A Monetary InjectionMS2Moneysupply,MSAggregatedemand,ADYYPMoney demand at price level PAD2
24、Quantityof Money0InterestRaterr2(a)The Money Market(b)The Aggregate-Demand CurveQuantityof Output0PriceLevel3.which increases the quantity of goods and services demanded at a given price level.2.theequilibriuminterest ratefalls.1.When the Fedincreases themoney supply.Copyright 2004 South-Western Whe
25、n 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 aggregate-demand to the right.When the Fed contracts the money supply,it raises the interest rate and reduces the quantity of goods and service
26、s demanded at any given price level,shifting aggregate-demand 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 targe
27、t 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 aggregate demand.HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND Fiscal policy refers to the governments choices regarding the overall level of
28、government purchases or taxes.Fiscal policy influences saving,investment,and growth in the long run.In the short run,fiscal policy primarily affects the aggregate demand.Changes in Government Purchases When policymakers change the money supply or taxes,the effect on aggregate demand is indirectthrou
29、gh the spending decisions of firms or households.When the government alters its own purchases of goods or services,it shifts the aggregate-demand curve directly.Changes in Government Purchases There are two macroeconomic effects from the change in government purchases:The multiplier effect The crowd
30、ing-out effectThe Multiplier Effect Government purchases are said to have a multiplier effect on aggregate demand.Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.The Multiplier Effect The multiplier effect refers to the additional shift
31、s in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.Figure 4 The Multiplier EffectQuantity ofOutputPriceLevel0Aggregate demand,AD1$20 billionAD2AD31.An increase in government purchasesof$20 billion initially increases aggregatede
32、mand by$20 billion.2.but the multipliereffect can amplify theshift in aggregatedemand.Copyright 2004 South-WesternA Formula for the Spending Multiplier The formula for the multiplier is:Multiplier=1/(1-MPC)An important number in this formula is the marginal propensity to consume(MPC).It is the fract
33、ion of extra income that a household consumes rather than saves.If the MPC is 3/4,then the multiplier will be:Multiplier=1/(1-3/4)=4 In this case,a$20 billion increase in government spending generates$80 billion of increased demand for goods and services.The Crowding-Out Effect Fiscal policy may not
34、 affect the economy as strongly as predicted by the multiplier.An increase in government purchases causes the interest rate to rise.A higher interest rate reduces investment spending.The Crowding-Out Effect This reduction in demand that results when a fiscal expansion raises the interest rate is cal
35、led the crowding-out effect.The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.Figure 5 The Crowding-Out EffectQuantityof MoneyQuantity fixedby the Fed0InterestRaterMoney demand,MDMoneysupply(a)The Money Market3.whichincreasestheequilibriuminterestrate.2.the inc
36、rease inspending increasesmoney demand.MD2Quantityof Output0PriceLevelAggregate demand,AD1(b)The Shift in Aggregate Demand4.which in turnpartly offsets theinitial increase inaggregate demand.AD2AD31.When an increase in government purchases increases aggregatedemand.r2$20 billionCopyright 2004 South-
37、WesternThe Crowding-Out Effect When the government increases its purchases by$20 billion,the aggregate demand for goods and services could rise by more or less than$20 billion,depending on whether the multiplier effect or the crowding-out effect is larger.Changes in Taxes When the government cuts pe
38、rsonal income taxes,it increases households take-home pay.Households save some of this additional income.Households also spend some of it on consumer goods.Increased household spending shifts the aggregate-demand curve to the right.The size of the shift in aggregate demand resulting from a tax chang
39、e is affected by the multiplier and crowding-out effects.It is also determined by the households perceptions about the permanency of the tax change.USING POLICY TO STABILIZE THE ECONOMY Economic stabilization has been an explicit goal of U.S.policy since the Employment Act of 1946.The Case for Activ
40、e Stabilization Policy The Employment Act has two implications:The government should avoid being the cause of economic fluctuations.The government should respond to changes in the private economy in order to stabilize aggregate demand.The Case against Active Stabilization Policy Some economists argu
41、e that monetary and fiscal policy destabilizes the economy.Monetary and fiscal policy affect the economy with a substantial lag.They suggest the economy should be left to deal with the short-run fluctuations on its own.Automatic Stabilizers Automatic stabilizers are changes in fiscal policy that sti
42、mulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.Automatic stabilizers include the tax system and some forms of government spending.Summary Keynes proposed the theory of liquidity preference to explain determinants of the intere
43、st rate.According to this theory,the interest rate adjusts to balance the supply and demand for money.An increase in the price level raises money demand and increases the interest rate.A higher interest rate reduces investment and,thereby,the quantity of goods and services demanded.The downward-slop
44、ing aggregate-demand curve expresses this negative relationship between the price-level and the quantity demanded.Summary Policymakers can influence aggregate demand with monetary policy.An increase in the money supply will ultimately lead to the aggregate-demand curve shifting to the right.A decrea
45、se in the money supply will ultimately lead to the aggregate-demand curve shifting to the left.Summary Policymakers can influence aggregate demand with fiscal policy.An increase in government purchases or a cut in taxes shifts the aggregate-demand curve to the right.A decrease in government purchase
46、s or an increase in taxes shifts the aggregate-demand curve to the left.Summary When the government alters spending or taxes,the resulting shift in aggregate demand can be larger or smaller than the fiscal change.The multiplier effect tends to amplify the effects of fiscal policy on aggregate demand
47、.The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.Summary Because monetary and fiscal policy can influence aggregate demand,the government sometimes uses these policy instruments in an attempt to stabilize the economy.Economists disagree about how active the g
48、overnment should be in this effort.Advocates say that if the government does not respond the result will be undesirable fluctuations.Critics argue that attempts at stabilization often turn out destabilizing.Discussion Suppose the government reduces taxes by$100 million,that there is no crowding out,
49、and that the marginal propensity to consume is 0.6.a.What is the initial effect of the tax reduction on aggregate demand?What is the total effect of the tax cut on aggregate demand?b.How does the total effect of this$100 million tax cut compare to the total effect of a$100 million increase in govern
50、ment purchases?Why?a.The initial effect of the tax reduction of$100 million is to increase aggregate demand by$100 million x 0.6(the MPC)=$60 million.Additional effects follow this initial effect as the added incomes get spent.The second round leads to increased consumption spending of$60 million x
