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LU11 The Influence of Monetary and Fiscal Policy on Aggregate Demand (The…
LU11 The Influence of Monetary and Fiscal Policy on Aggregate Demand
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
The Theory of Liquidity Preference (Keynes)
The money supply is controlled by BNM through:
• Open-market operations
• Changing the reserve requirements
• Changing the discount rate
Money Demand
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
The Downward Slope of the Aggregate-Demand Curve
• Price level is one determinant of the quantity of money demanded.
• Higher price level increases the quantity of money demanded for any given interest rate.
• Higher money demand leads to a higher interest rate.
• Quantity of goods and services demanded falls.
Changes in the Money Supply
• BNM 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
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.
There are two macroeconomic effects from the change in government purchases:
The multiplier effect
Refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending
Multiplier = 1/(1 – MPC)
A Formula for the Spending Multiplier
If the MPC = 3/4, then the multiplier will be:
Multiplier = 1/(1 – 3/4) = 4
The crowding-out effect
This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.