The Influence of Monetary and Fiscal Policy on Aggregate DemandAggregate DemandAggregate DemandHow Monetary Policy Influences Aggregate DemandSlide 5The Theory of Liquidity PreferenceMoney SupplySlide 8Money DemandSlide 10Slide 11Equilibrium in the Money MarketSlide 13Equilibrium in the Money Market...The Downward Slope of the Aggregate Demand CurveSlide 16Slide 17Changes in the Money SupplyA Monetary Injection...Slide 20The Role of Interest-Rate Targets in Fed PolicyHow Fiscal Policy Influences Aggregate DemandChanges in Government PurchasesSlide 24The Multiplier EffectThe Multiplier Effect...A Formula for the Spending MultiplierSlide 28The Crowding-Out EffectSlide 30The Crowding-Out Effect...Slide 32Changes in TaxesSlide 34Using Policy to Stabilize the EconomyThe Case for Active Stabilization PolicyThe Case Against Active Stabilization PolicyAutomatic StabilizersSummarySlide 40Slide 41Slide 42Slide 43Slide 44Slide 45Slide 46Slide 47Slide 48Slide 49Slide 50The Influence of Monetary and Fiscal Policy on Aggregate DemandChapter 32Copyright © 2001 by Harcourt, Inc.All rights reserved. Requests for permission to make copies of any part of thework should be mailed to:Permissions Department, Harcourt College Publishers,6277 Sea Harbor Drive, Orlando, Florida 32887-6777.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.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.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.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.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.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 effectHarcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.How Monetary Policy Influences Aggregate DemandFor the U.S. economy, the most important reason for the downward slope of the aggregate-demand curve is the interest-rate effect.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.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.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.Money SupplyThe money supply is controlled by the Fed through:Open-market operationsChanging the reserve requirementsChanging the discount rateHarcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.Money Supply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.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.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.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.Money DemandPeople choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.Money Demand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.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.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.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.Equilibrium in the Money MarketAssume 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.Equilibrium in the Money Market...Quantity ofMoneyInterestRate0MoneydemandQuantity fixedby the FedMoneysupplyr2M d2r1M d1Equilibrium interest rateHarcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.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.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.The Downward Slope of the Aggregate Demand CurveThe end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded.Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.Aggregate demand(b) The Aggregate Demand CurveQuantity of Output0Price Level(a) The Money MarketQuantity of MoneyQuantity fixed by the Fed0r1Money supplyInterest RateMoney demand at price level P1, MD1Y1P1The Money Market and the Slope of the Aggregate Demand Curve...Money demand atprice level P2, MD22. …increases the demand for money…1. An increase in the price level…P23. …which increases the equilibrium equilibrium rate…r24. …which in turn reduces the quantity of goods and services demanded.Y2Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.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