Lu11: The Influence of Monetary and Fiscal Policy On Aggregate Demad
How Monetary Policy influences AD
How Fiscal policy influences AD
Policy for economic stabilization
AD curve slopes downward for 3 reasons:
1.The wealth effect
- The interest-rate effect
- The exchange-rate effect
The Theory of Liquidity Preference
to explain what factors determine the economy’s interest rate.
the interest rate adjusts to balance the supply and demand for money
to explain both nominal and real rates by holding constant the rate of inflation.
Money Supply
The money supply is controlled by BNM through:
Open-market operations
Changing the reserve requirements
Changing the discount rate
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
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
determined by several factors
An increase in the interest rate raises the opportunity cost of holding money.
Q of money demanded is reduced
Equilibrium in the Money Market
The interest rate adjusts to balance the supply and demand for money.
Q Md= Q Ms
The price level is stuck at some level.
refers to the government’s choices regarding the overall level of government purchases or taxes.
Fiscal policy influences saving, investment, and growth in the LR.
In SR, fiscal policy primarily affects the AD.
Changes in Government Purchases
The multiplier effect
The crowding-out effect
The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.
This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.
The formula for the multiplier is:
Multiplier = 1/(1 – MPC)
An important number in this formula is the marginal propensity to consume (MPC).
The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.
The government should avoid being the cause of economic fluctuations.
to changes in the private economy in order to stabilize aggregate demand.
Monetary and fiscal policy affect the economy with a substantial lag.
Automatic stabilizers include the tax system and some forms of government spending.