CHAP 21: THE INFLUENCE OF MONETARY AND FISCAL POLICY ON

AGGREGATE DEMAND
I. Monetary policy
1. Theory of liquidity preference
State: the interest rate adjusts to balance supply and demand for money
Assume: expected rate of inflation is constant
 Money supply: assumed fixed by central bank, does not depend on interest
rate
 Money demand:
+ Reflects how much wealth people want to hold in liquid form
+ Variables that influence money demand : Y, r, and P
+ Interest rate is the cost of holding money :
- ↑ interest rate → ↑ cost of holding money → ↓ quantity of money
demanded
- ↓interest rate →↓ cost of holding money → ↑ quantity of money
demanded
Active learning 1:
a. Suppose real income (Y) rises, what happen to money demand ?
 An increase in Y causes an increase in money demand, other things equal
b. Suppose r rises, but Y and P are unchanged. What happens to money demand ?
 An increase in r cause a decrease in money demand
c. Suppose P rise, but Y and r are unchanged. What happens to money demand ?
 If Y is unchanged, people will buy the same amount of G&S. However, P rises
so people will need more money, causing an increase in money demand

2. How the Interest-Rate Effect works ?

 3. Monetary Policy and the AD

1. The Fed:
+ Use monetary policy to shift the AD curve
+ Conduct open market operations to change MS
+ Targets the interest rate: the federal funds rate

Active learning 2:
For each of the events below,
Determine the short-run effects on output
Determine how the Fed should adjust the money supply and interest rates to stabilize
output
A. Congress tries to balance the budget by cutting government spending.
B. A stock market boom increases household wealth.
C. War breaks out in the Middle East, causing oil prices to soar.
 Solve:
A. The events ↓C → ↓ AD + output
To adjust, we need to ↑C by ↑ MS + ↓r
B. The events ↑C → ↑AD + output
To adjust, we need to ↓AD by ↓AS + ↑r
C. The events ↓ AS → ↓ output
To adjust, we need to ↑AS by ↓r + ↑AD

2. Liquidity trap
+ If interest rates fall to around zero, monetary policy may no longer be
effective
+ Since nominal interest rates cannot be reduced further
 AD, production and employment may be trapped at low levels
+ Tools:

II. Fiscal policy

State: Setting the level of government spending and taxation by government
policymakers
Expansionary fiscal policy: an increase in G and/or decrease in T, shift AD right
Contractionary fiscal policy: an decrease in G and/or increase in T, shift AD left
Fiscal policy has 2 effects on AD: The Multiplier effect and The Crowding-Out effect
1. The Multiplier Effect
- State: the additional shifts in AD that result when expansionary fiscal
policy increases income and thereby increases consumer spending.

- Example: If the government buys $20b of planes from Boeing,

Boeing’s revenue increases by $20b.
+ This is distributed to Boeing’s
workers (as wages) and owners (as
profits or stock dividends)
+ These people are also consumers
and will spend a portion of the extra
income
+ This extra consumption causes
further increases in AD

- Also true for other components of GDP

- How big is the multiplier effect depends on how much consumers
respond to increase in income
- Marginal propensity to consume: fraction of extra income that
households consume rather than save
MPC=ΔC/ΔY

2. The Crowding-Out Effect

 State: the offset in aggregate demand that results when expansionary fiscal policy
raises the interest rate and thereby reduces investment spending → reduce AD

Active learning 3:
The economy is in recession.
Shifting the AD curve rightward by $200b would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G to end the recession?
B. If there is crowding out, will Congress need to increase G more or less than this
amount?
 Solve:
A. Multiplier = 1/(1-0.8) = 5
In order to shift AD $200b, we need to increase G by $40b
B. Since crowding-out effect reduces the impact of G on AD
To offset this, Congress should increase G by a larger amount (>40)

3. Changes in Taxes
Increase take-home pay → households respond by spending a portion of this extra
income → shift AD to the right
 Note: the determinant of the size of the shift
- is affected by the multiplier and crowding-out effect
- households perception
 → permanent tax cut – large impact on AD
temporary tax cut – small impact on AD

III. Automatic Stabilizers

 During recessions: GO collect less taxes, pay more unemployment &
welfare benefits → increase deficit
 During booms: GO collect more taxes, pay less unemployment & welfare
benefits → increase surplus