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How monetary policy influences aggregate demand:
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- The wealth effect
- The interest-rate effect
- The exchange-rate effect
- The interest-rate effect
- The exchange-rate effect
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The wealth effect
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a lower price level raises the real value of households' money holdings, which are part of their wealth. Higher real wealth stimulates consumer spending and thus increases the quantity of goods and services demanded.
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The interest-rate effect
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A lower price level reduces the amount of money people want to hold. As people try to lend out their excess money holdings, the interest rate falls. The lower interest rate stimulates investment spending and thus increases the quantity of goods and services demanded.
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The exchange-rate effect
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when a lower price level reduces the interest rate, investors move some of their funds overseas in search of higher return. This movement of funds causes the real value of the domestic currency to fall in the market for foreign-currency exchange. Domestic goods become less expensive relative to foreign goods. This change in the real exchange rate stimulates spending on net exports and thus increases the quantity of goods and services demanded.
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Theory of liquidity preference
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Keynes's theory that the interest rate adjusts to bring money supply and money demand into balance
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Equilibrium in the money Market:
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- According to the theory of liquidity preference, the interest rate adjusts the quantity of money supplied and quantity of money demanded into balance.
- If the interest rate is above the equilibrium level, the quantity of money people want to hold is less than the quantity the FED has created, and this surplus of money puts downward pressure on the interest rate
- If the interest rate is below the equilibrium level, the quantity of money people want to hold is greater than the quantity the FED has created, and this storage of money puts upward pressure on the interest rate
- Thus the forces of supply and demand in the market for money push the interest rate toward the equilibrium interest rate, at which people are content holding the quantity of money the FED has created
- If the interest rate is above the equilibrium level, the quantity of money people want to hold is less than the quantity the FED has created, and this surplus of money puts downward pressure on the interest rate
- If the interest rate is below the equilibrium level, the quantity of money people want to hold is greater than the quantity the FED has created, and this storage of money puts upward pressure on the interest rate
- Thus the forces of supply and demand in the market for money push the interest rate toward the equilibrium interest rate, at which people are content holding the quantity of money the FED has created
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Interest Rates in the Long Run and the Short Run
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1. Output is determined by the supplies of capital and labor and the available production technology for turning capital and labor into output
2. For any given level of output, the interest rate adjusts to balance the supply and demand for loanable funds
3. Given output and the rate, the price level adjusts to balance the supply and demand for money. Changes in the supply of money lead to proportionate changes in the price level.
2. For any given level of output, the interest rate adjusts to balance the supply and demand for loanable funds
3. Given output and the rate, the price level adjusts to balance the supply and demand for money. Changes in the supply of money lead to proportionate changes in the price level.
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Operation of the economy in the short run
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1. The price level stuck at some level, in the short run, is relatively unresponsive to changing economic conditions
2. For any given (stuck) price level, the interest rate adjusts to balance supply of and demand for money
3. The interest rate that balances the money market influences the quantity of goods and services demanded and thus the level of output
2. For any given (stuck) price level, the interest rate adjusts to balance supply of and demand for money
3. The interest rate that balances the money market influences the quantity of goods and services demanded and thus the level of output
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The Money Market and the Slope of the Aggregate-Demand Curve:
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- An increase in the price level shifts the money-demand curve to the right
- This increase in money demand causes the interest rate to rise
- Because the interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods and services demanded.
- This negative relationship between the price level and quantity demanded is represented with a downward-sloping aggregate-demand curve
- This increase in money demand causes the interest rate to rise
- Because the interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods and services demanded.
- This negative relationship between the price level and quantity demanded is represented with a downward-sloping aggregate-demand curve
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Interest-rate effect summarized:
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1. A higher price level raises money demand
2. Higher money demand leads to a higher interest rate
3. A higher interest rate reduces the quantity of goods and services demanded
2. Higher money demand leads to a higher interest rate
3. A higher interest rate reduces the quantity of goods and services demanded
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A Monetary Injection:
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- A increase in the money supply reduces the equilibrium interest rate
- Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of goods and services demanded at a given price level
- Thus, the aggregate-demand curve shifts to the right
- Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of goods and services demanded at a given price level
- Thus, the aggregate-demand curve shifts to the right
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Fiscal policy
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the setting of the level of government spending and taxation by government policymakers
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Multiplier effect
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the additional shift in aggregate demand that results when expansionary fiscal policy increases income and thereby increases consumer spending
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The Multiplier Effect:
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An increase in government purchases of X can shift the aggregate-demand curve to the right more than X. this multiplier effect arises because increases in aggregate income stimulate additional spending by consumers.
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Multiplier =
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1/(1-MPC)
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Crowding-out effect
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the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending
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The Crowding-Out Effect:
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- In the money market, when the government increases its purchases of goods and services, the resulting increase in income raises the demand for money, causing the equilibrium interest rate to rise.
- the initial impact of the increase in government purchases shifts the aggregate demand curve to the right. Yet, because the interest rate is the cost of borrowing, the increase in the interest rate tends to reduce the quantity of goods and services demanded, particularly for investment goods.
- This crowding out of the investment partially offsets the impact of the fiscal expansion on aggregate demand.
- In the end, the aggregate-demand curve shifts only partially to the right
- the initial impact of the increase in government purchases shifts the aggregate demand curve to the right. Yet, because the interest rate is the cost of borrowing, the increase in the interest rate tends to reduce the quantity of goods and services demanded, particularly for investment goods.
- This crowding out of the investment partially offsets the impact of the fiscal expansion on aggregate demand.
- In the end, the aggregate-demand curve shifts only partially to the right
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Automatic Stabilizers
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changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action
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Advocates of active stabilizing policy claim:
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changes in attitudes by households and firms shift aggregate demand, and if the government doesn't respond, the result is undesirable and unnecessary fluctuation in output and employment
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Critics of active stabilization policy, claim
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monetary and fiscal policy work with such long lags that attempts at stabilizing the economy often end up being destabilizing
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A decrease in the price level allows people to hold less money. Thus a lower price level causes the quantity of money demanded to decrease at each interest rate, shifting the money demand curve to the
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left
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Which of the following best describes how an increase in the money supply shifts aggregate demand?
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The money supply shifts right, the interest rate falls, investment increases, and aggregate demand shifts right
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When the supply and demand for money are expressed in a graph with the interest rate on the vertical axis and the quantity of money on the horizontal axis, an increase in the price level
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shifts money demand to the right and increases the interest rate.
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Many economists prefer automatic stabilizers because they affect the economy with a shorter lag than activist stabilization policies.
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True
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The initial impact of an increase in government spending is to shift
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aggregate demand to the right.
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Which of the following is an automatic stabilizer?
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unemployment benefits
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An increase in the interest rate increases the quantity demanded of money because it increases the rate of return on money.
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False: An increase in the interest rate decreases the quantity demanded of money because it raises the opportunity cost of holding money.
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Crowding out occurs when an increase in government spending increases incomes, shifts money demand to the right, raises the interest rate, and reduces private investment.
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True
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Because of the multiplier effect, an increase in government spending of $40 billion will shift the aggregate-demand curve to the right by more than $40 billion (assuming there is no crowding out).
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True
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Suppose a wave of investor and consumer optimism has increased spending so that the current level of output exceeds the long-run natural rate. If policymakers choose to engage in activist stabilization policy, they should
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decrease government spending, which shifts aggregate demand to the left.
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Which of the following statements regarding taxes is correct?
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A permanent change in taxes has a greater effect on aggregate demand than a temporary change in taxes.
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For the United States, the most important source of the downward slope of the aggregate-demand curve is
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the interest-rate effect.
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When an increase in government purchases raises incomes, shifts money demand to the right, raises the interest rate, and lowers investment, we have seen a demonstration of
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the crowding-out effect.
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Suppose the government increases its purchases by $16 billion. If the multiplier effect exceeds the crowding-out effect, then
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the aggregate-demand curve shifts to the right by more than $16 billion.
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The long-run effect of an increase in the money supply is to
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increase the price level.
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When an increase in government purchases increases the income of some people, and those people spend some of that increase in income on additional consumer goods, we have seen a demonstration of
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The Multiplier effect
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Suppose the government increases its expenditure by $10 billion. If the crowding-out effect exceeds the multiplier effect, then the aggregate-demand curve shifts to the right by more than $10 billion
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False: The aggregate-demand curve shifts to the right by less than $10 billion.
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In the market for real output, the initial effect of an increase in the money supply is to
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shift aggregate demand to the right.
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When an increase in government purchases causes firms to purchase additional plant and equipment, we have seen a demonstration of
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the investment accelerator.
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Keynes's liquidity preference theory of the interest rate suggests that the interest rate is determined by
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the supply and demand for money.
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If the marginal propensity to consume ( MPC ) is 0.75, the value of the multiplier is
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4
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