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The Influence of Monetary and Fiscal Policy on Aggregate Demand

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					The Influence of Monetary and Fiscal Policy on 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. 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 • For the U.S. economy, the most important reason for the downward slope of the aggregate-demand curve is the interest-rate effect. 1. Which of the following is not a reason the aggregate demand curve slopes downward? As the price level increases a. firms may believe the relative price of their output has risen. b. real wealth declines. c. the interest rate increases. d. the exchange rate increases. 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. • Liquidity preference theory attempts to explain both nominal and real rates by holding constant the rate of inflation. • Money 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 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 services. • 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.

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Equilibrium in the Money Market • According to the theory of 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. • Assume 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.
Figure 1 Equilibrium in the Money Market
Interest Rate Money supply

r1 Equilibrium interest rate r2 Money demand Md Quantity fixed by the Fed
d M2

0

Quantity of Money

2. According to the theory of liquidity preference, the money supply a. and money demand are positively related to the interest rate. b. and money demand are negatively related to the interest rate. c. is negatively related to the interest rate while money demand is positively related to the interest rate. d. is independent of the interest rate, while money demand is negatively related to the interest rate. 3. According to liquidity preference theory, the money supply curve would shift right a. if the money demand curve shifted right. b. if the Federal Reserve chose to increase money supply. c. if the interest rate increased. d. All of the above are correct. 4. According to liquidity preference theory, the money supply curve would shift if the Fed a. engaged in open-market transactions. b. changed the discount rate. c. changed the reserve requirement. d. did any of the above. 5. Liquidity refers to a. the relation between the price and interest rate of an asset. b. the risk of an asset relative to its selling price. c. the ease with which an asset is converted into a medium of exchange. d. the sensitivity of investment spending to changes in the interest rate.

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6. According to liquidity preference theory, the opportunity cost of holding money is a. the interest rate on bonds. b. the inflation rate. c. the cost of converting bonds to a medium of exchange. d. the difference between the inflation rate and the interest rate on bonds. 7. When the interest rate increases, the opportunity cost of holding money a. increases, so the quantity of money demanded increases. b. increases, so the quantity of money demanded decreases. c. decreases, so the quantity of money demanded increases. d. decreases, so the quantity of money demanded decreases. 8. According to liquidity preference theory, if the quantity of money demanded is greater than the quantity supplied, the interest rate will a. increase and the quantity of money demanded will decrease. b. increase and the quantity of money demanded will increase. c. decrease and the quantity of money demanded will decrease. d. decrease and the quantity of money demanded will increase. 9. If there is excess money demand, people will a. deposit more into interest-bearing accounts, and the interest rate will fall. b. deposit more into interest-bearing accounts, and the interest rate will rise. c. withdraw money from interest-bearing accounts, and the interest rate will fall. d. withdraw money from interest-bearing accounts, and the interest rate will rise. 10. If there is excess money supply, people will a. deposit more into interest-bearing accounts, and the interest rate will fall. b. deposit more into interest-bearing accounts, and the interest rate will rise. c. withdraw money from interest-bearing accounts, and the interest rate will fall. d. withdraw money from interest-bearing accounts, and the interest rate will rise.

The 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. • Higher money demand leads to a higher interest rate. • The quantity of goods and services demanded falls. • The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded.

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Figure 2 The Money Market and the Slope of the Aggregate-Demand Curve
(a) The Money Market Interest Rate Money supply 2. . . . increases the demand for money . . . r2 Money demand at price level P2 , MD2 r 3. . . . which increases the equilibrium 0 interest rate . . . 1. An P increase in the price level . . . 0 P2 Price Level (b) The Aggregate-Demand Curve

Money demand at price level P , MD Quantity fixed by the Fed Quantity of Money

Aggregate demand Quantity of Output 4. . . . which in turn reduces the quantity of goods and services demanded. Y2 Y

11. According to liquidity preference theory, if the price level decreases, then a. the interest rate falls because money demand shifts right. b. the interest rate falls because money demand shifts left. c. the interest rate rises because money supply shifts right. d. the interest rate rises because money supply shifts left. 12. According to liquidity preference theory, if the price level increases, then the equilibrium interest rate a. rises and the aggregate quantity of goods demand rises. b. rises and the aggregate quantity of goods demanded falls. c. falls and the aggregate quantity of goods demanded rises. d. falls and the aggregate quantity of goods demanded falls. 13. Which of the following properly describes the interest-rate effect that helps explain the slope of the aggregate demand curve? a. As the money supply increases, the interest rate falls, so spending rises. b. As the money supply increases, the interest rate rises, so spending falls. c. As the price level increases, the interest rate falls, so spending rises. d. As the price level increases, the interest rate rises, so spending falls.

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.

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Figure 3 A Monetary Injection
(a) The Money Market Interest Rate Money supply, MS MS2 Price Level (b) The Aggregate-Demand Curve

r

1. When the Fed increases the money supply . . .

P

2. . . . the equilibrium interest rate falls . . .

r2 Money demand at price level P 0 Quantity of Money 0 Y Y

AD2 Aggregate demand, AD Quantity of Output

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

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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 decreases 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 aggregate demand. 14. If the Federal Reserve decided to lower interest rates, it could a. buy bonds to lower the money supply. b. buy bonds to raise the money supply. c. sell bonds to lower the money supply. d. sell bonds to raise the money supply.

HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND • Fiscal policy refers to the government’s choices regarding the overall level of 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 indirect—through 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. • There are two macroeconomic effects from the change in government purchases: • The multiplier effect • The crowding-out effect

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The 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 refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.
Figure 4 The Multiplier Effect
Price Level

2. . . . but the multiplier effect can amplify the shift in aggregate demand. $20 billion

AD3 AD2 Aggregate demand, AD1 0 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion . . . Quantity of Output

A 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 fraction of extra income that a household consumes rather than saves. • If the MPC = 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. • A larger MPC means a larger multiplier in an economy. • The multiplier effect is not restricted to changes in government spending. • • • • • Fiscal policy may not 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. This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

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Figure 5 The Crowding-Out Effect

(a) The Money Market Interest Rate Money supply 2. . . . the increase in spending increases money demand . . . r2 Price Level

(b) The Shift in Aggregate Demand 4. . . . which in turn partly offsets the initial increase in aggregate demand.

$20 billion

AD2 r M D2 Money demand, MD 0 Quantity fixed by the Fed Quantity of Money 0 1. When an increase in government purchases increases aggregate demand . . . Aggregate demand, AD1 Quantity of Output AD3

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.

15. Suppose that there is a multiplier effect that is greater than one and that there are no crowding out or investment accelerator effects. Which of the following would shift aggregate demand right by more than the increase in expenditures? a. an increase in government expenditures. b. an increase in net exports. c. an increase in investment spending. d. All of the above are correct. 16. Which of the following illustrates how the investment accelerator works? a. An increase in government expenditures increases aggregate spending so that Gas-n-Go decides to modernize its gas stations. b. An increase in government expenditures increases the interest rate so that Gas-n-Go decides to modernize its gas stations. c. An increase in government expenditures increases the interest rate so that the demand for stocks and bonds issued by Gas-n-Go rises. d. An increase in government expenditures decreases the interest rate so that Gas-n-Go decides to modernize its gas stations. 17. The marginal propensity to consume (MPC) is defined as the fraction of a. extra income that a household consumes rather than saves. b. extra income that a household either consumes or saves. c. total income that a household consumes rather than saves. d. total income that a household either consumes or saves. 18. If the MPC = .85, then the government purchases multiplier is about ________

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19. According to the crowding-out effect, an increase in government spending a. increases the interest rate and so increases investment spending. b. increases the interest rate and so decreases investment spending. c. decreases the interest rate and so increases investment spending. d. decreases the interest rate and so decreases investment spending. 20. The multiplier effect a. and the crowding-out effect both amplify the effects of an increase in government expenditures. b. and the crowding-out effect both diminish the effects of an increase in government expenditures. c. diminishes the effects of an increase in government expenditures, while the crowding-out effect amplifies the effects. d. amplifies the effects of an increase in government expenditures, while the crowding-out effect diminishes the effects. Changes in Taxes • When the government cuts personal 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 change is affected by the multiplier and crowding-out effects. • It is also determined by the households’ perceptions about the permanency of the tax change. 21. If taxes a. increase, consumption increases, aggregate demand shifts right. b. increase, consumption decreases, aggregate demand shifts left. c. decrease, consumption increases, aggregate demand shifts left. d. decrease, consumption decreases, aggregate demand shifts right.

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