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.


                                                                                               1
    •   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

                                   0          Md      Quantity fixed     d
                                                                        M2   Quantity of
                                                       by the Fed               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.




                                                                                                  3
Figure 2 The Money Market and the Slope of the Aggregate-Demand Curve
                     (a) The Money Market                                         (b) The Aggregate-Demand Curve

     Interest                Money                                     Price
        Rate                 supply                                    Level
                                      2. . . . increases the
                                      demand for money . . .

           r2                                                              P2
                                          Money demand at
                                          price level P2 , MD2
            r                                                    1. An       P
3. . . .
which                                                            increase
                                          Money demand at        in the                                             Aggregate
increases
                                          price level P , MD     price                                               demand
the
equilibrium 0                                                    level . . . 0
                    Quantity fixed                  Quantity                            Y2              Y               Quantity
interest
                     by the Fed                    of Money                                                            of Output
rate . . .
                                                                                 4. . . . which in turn reduces the quantity
                                                                                 of goods and services demanded.



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.




                                                                                                                                   4
Figure 3 A Monetary Injection
                            (a) The Money Market                            (b) The Aggregate-Demand Curve
            Interest                                             Price
               Rate       Money       MS2                        Level
                          supply,
                          MS

                  r                         1. When the Fed         P
                                            increases the
                                            money supply . . .
2. . . . the      r2
                                                                                                           AD2
equilibrium
interest rate                                 Money demand                                                Aggregate
falls . . .                                   at price level P                                           demand, AD
                  0                                  Quantity       0         Y        Y                     Quantity
                                                    of Money                                                of Output
                                                                    3. . . . which increases the quantity of goods
                                                                    and services demanded at a given price level.



     •     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 aggregate-
           demand 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 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 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                                                                     Quantity of
                    1. An increase in government purchases                              Output
                    of $20 billion initially increases aggregate
                    demand by $20 billion . . .




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.




                                                                                                    6
    Figure 5 The Crowding-Out Effect


                       (a) The Money Market                                            (b) The Shift in Aggregate Demand

Interest                                                               Price
              Money                                                                                              4. . . . which in turn
    Rate                                                               Level
              supply                                                                                             partly offsets the
                                2. . . . the increase in                                    $20 billion          initial increase in
                                spending increases                                                               aggregate demand.
                                money demand . . .
      r2

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


    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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