Infl uence of Monetary and Fiscal Policy on Aggregate

Demand

Orange Brigade

Theory of Liquidity Preference- Keynes's Theory that Interest rate adjusts to bring Money Supply and demand into Balance 1. Money Supply- Fixed by Central Bank, unresponsive to

interest rate2. Money Demand- recall components that affect AD curve

3. Equilibrium in Money Market- If interest rate isn’t at equilibrium, people will buy or sell assets to drive market towards equilibrium.

As real income rises, Households purchase more goods and services, so demand for money increases.Households sell bonds to increase money holdings

Increase in IR increases cost of holding money. Therefore, quantity of money demanded decreases. Decreasing IR decreases cost of holding money, so money demand increases

As a result, Money Demand curve slopes downwards

M

Interest rate MS

Quantity fixed by the

Fed

MD1

r1

Determination of IR

Monetary Policy and Aggregate Demand

Fed uses monetary policy to shift the aggregate Demand curve by altering the money supply.

Recall that the Fed adjusts the interest rate by changing the Fed Funds Rate

Fed uses Open Market operations to change the interest rate and to shift the AD curve

THE INFLUENCE OF MONETARY AND FISCAL POLICY 5

The Effects of Reducing the Money Supply

Y

P

M

Interest rate

AD1

MS1

MD

P1

Y1

r1

MS2

r2

AD2Y2

The Fed can raise r by reducing the money supply.

An increase in r reduces the quantity of g&s demanded.

Fiscal Policy- Setting of the level of government spending and taxation

increase in government purchases or decrease in taxation

Expansionary policies shift AD rightwards

Contractionary policies shift AD leftwards

decrease in government purchases or increase in taxation

Multiplier effect- additional shifts in AD resulting when fiscal policy increases income and thereby consumer spending.

Increase in real income increases consumer spending, ` shifting AD rightwardsMarginal Propensity to Consume- Fraction of extra income households consume rather than save

G is the change in G, Y and C are the ultimate changes in Y and C

Y = C + I + G + NX identity

Y = C + G I and NX do not change

Y = MPC Y + G because C = MPC Y

solved for Y

11 – MPC

Y = G

Formula for the multiplier:

Y

P

AD1

P1

AD2

AD3

Y1

The Multiplier Effect

Crowding-Out Effect is also affected by Fiscal Policy

Expansionary policy increases interest rate,which reduces investment, which reduces the net increase in aggregate demand.

So, the size of the AD shift may be smaller than the initial fiscal expansion.

Changes in Taxes

Tax cuts increase take-home pay for households, increasing consumer spending and shifting AD to the right.

If household perceives tax cut to be permanent, shift is larger.

Using policy to stabilize the economy

Active stabilization- supporters of active stabilization believe it is the government’s responsibility to regulate the economy.

Expansionary policy should be used during a recession, contractionary policy should be used during periods of

rapid inflation

Booms, recessions, and crashes cause fluctuations in the market

Against Active stabilization- critics of active stabilization claim that monetary and fiscal policy affects economy with a long lag

Because firms create investment plans in advance, investment takes time to respond to changes in IRBecause government purchases and taxes require congressional approval, G and T require timeThese lags can destabilize the economyAutomatic stabilizers- changes in fiscal policy that

stimulate AD when economy goes into recession, without policymakers having to take any deliberate action

Include tax system and government spending