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:
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• 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:
Assume the following about the economy:
• 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
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• 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
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• 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
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• 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
The crowding-out 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)
This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.
A Formula for the Spending Multiplier
If the MPC = 3/4, then the multiplier will be:
Multiplier = 1/(1 – 3/4) = 4