MACROECONOMICS I
The Influence of Monetary
and Fiscal Policy on Aggregate Demand
Lecture 10
May 13, 2022
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LOOK FOR THE ANSWERS TO THESE
QUESTIONS:
How does the interest-rate effect help explain the
slope of the aggregate-demand curve?
How can the central bank use monetary policy to
shift the AD curve?
In what two ways does fiscal policy affect
aggregate demand?
What are the arguments for and against
using policy to try to stabilize the economy?
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INTRODUCTION
Earlier chapters covered:
 Long-run effects of fiscal policy on interest
rates, investment, economic growth
 Long-run effects of monetary policy on the
price level and inflation rate
This chapter focuses on
 Short-run effects of fiscal and monetary policy,
which work through aggregate demand
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AGGREGATE DEMAND
Recall, the AD curve slopes downward for three
reasons:
 The wealth effect
 The interest-rate effect
 The exchange-rate effect
Next:
 A supply-demand model that helps explain the
interest-rate effect and how monetary policy
affects aggregate demand.
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the most important
of these effects for
the U.S. economy
THEORY OF LIQUIDITY PREFERENCE
The theory of liquidity preference
 A simple theory of the interest rate (r)
➢ r adjusts to balance supply and demand
for money
➢ Nominal interest rate, real interest rate
 Assumption: expected rate of inflation is constant
Money supply:
 Assumed fixed by central bank, does not depend
on interest rate
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THEORY OF LIQUIDITY PREFERENCE
Money demand
 Reflects how much wealth people want to hold
in liquid form
 Assume household wealth includes only two
assets:
➢ Money – liquid but pays no interest
➢ Bonds – pay interest but not as liquid
 A household’s “money demand” reflects its
preference for liquidity
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THEORY OF LIQUIDITY PREFERENCE
Variables that influence money demand:
 Y, r, and P.
Suppose real income (Y) rises:
 Households want to buy more goods and services,
so they need more money
 To get this money, they attempt to sell some of
their bonds.
An increase in Y causes an increase in money demand,
other things equal. 7
ACTIVE LEARNING 1
THE DETERMINANTS OF MONEY DEMAND
A. Suppose r rises, but Y and P are unchanged. What
happens to money demand?
B. Suppose P rises, but Y and r are unchanged. What
happens to money demand?
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ACTIVE LEARNING 1 ANSWERS
A. Suppose r rises, but Y and P are unchanged.
What happens to money demand?
 r is the opportunity cost of holding money.
 An increase in r reduces money demand:
households attempt to buy bonds to take
advantage of the higher interest rate.
 Hence, an increase in r causes a decrease in
money demand, other things equal.
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ACTIVE LEARNING 1 ANSWERS
B. Suppose P rises, but Y and r are unchanged.
What happens to money demand?
 If Y is unchanged, people will want to buy the
same amount of goods and services.
 Since P is higher, they will need more money to
do so.
 Hence, an increase in P causes an increase in
money demand, other things equal.
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HOW R IS DETERMINED
MS curve is vertical:
Changes in r does not
affect MS, which is fixed
by the Fed.
MD curve is
downward sloping:
A fall in r increases
money demand.
M
Interest
rate MS
MD1
r1
Quantity fixed
by the Fed
Eq’m
interest
rate
HOW THE INTEREST-RATE EFFECT WORKS
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Y
P
M
Interest
rate
AD
MS
MD1
MD2
P2
P1
Y1 Y2
r2
r1
A fall in P reduces money demand, which lowers r.
A fall in r increases I and the quantity of g&s demanded.
MONETARY POLICY AND THE AD
The Fed
 Uses monetary policy to shift the AD curve
 Policy instrument: the money supply (MS)
 Targets the interest rate: the federal funds rate
 Banks charge each other on short-term loans
 Conducts open market operations to change MS
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THE EFFECTS OF REDUCING THE MONEY SUPPLY
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Y
P
M
Interest
rate
AD1
MS1
MD
P1
Y1
r1
MS2
r2
AD2
Y2
The Fed can raise r by reducing the money supply.
An increase in r reduces the quantity of g&s demanded.
ACTIVE LEARNING 2 MONETARY POLICY
For each of the events below,
- Determine the short-run effects on output
- Determine how the Fed should adjust the
money supply and interest rates to stabilize output
A. Congress tries to balance the budget by cutting
government spending.
B. A stock market boom increases household wealth.
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ACTIVE LEARNING 2 ANSWERS
A. Congress tries to balance the budget by
cutting government spending.
 This event would reduce aggregate demand
and output.
 To stabilize output, the Fed should increase MS
and reduce r to increase aggregate demand.
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ACTIVE LEARNING 2 ANSWERS
B. A stock market boom increases household wealth.
 This event would increase aggregate demand,
raising output above its natural rate.
 To stabilize output, the Fed should reduce MS
and increase r to reduce aggregate demand.
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LIQUIDITY TRAPS
Liquidity trap
 If interest rates have already fallen to around
zero
 Monetary policy may no longer be effective,
since nominal interest rates cannot be reduced
further
➢ Aggregate demand, production, and
employment may be "trapped" at low levels
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LIQUIDITY TRAPS
A central bank continues to have tools to expand
the economy:
 Forward guidance: raise inflation expectations
by committing to keep interest rates low
 Quantitative easing: buy a larger variety of
financial instruments (mortgages, corporate
debt, and longer-term government bonds) (The
Fed, 2008)
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FISCAL POLICY AND THE AD
Fiscal policy:
 Setting the level of government spending and taxation
by government policymakers
Expansionary fiscal policy
 An increase in G and/or decrease in T, shifts AD right
Contractionary fiscal policy
 A decrease in G and/or increase in T, shifts AD left
Fiscal policy has two effects on AD...
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1. THE MULTIPLIER EFFECT
Example: If the government buys $20b of planes from
Boeing, Boeing’s revenue increases by $20b.
 This is distributed to Boeing’s workers (as wages) and
owners (as profits or stock dividends).
 These people are also consumers and will spend a
portion of the extra income.
 This extra consumption causes further increases in
aggregate demand.
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1. THE MULTIPLIER EFFECT
A $20b increase in G
initially shifts AD
to the right by $20b.
The increase in Y causes C
to rise, which shifts AD
further to the right.
Multiplier effect: the
additional shifts in AD
that result when fiscal policy
increases income and thereby
increases consumer spending
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Y
P
AD1
P1
AD2
AD3
Y1 Y3Y2
$20 billion
MARGINAL PROPENSITY TO CONSUME
How big is the multiplier effect?
 Depends on how much consumers respond to
increases in income.
Marginal propensity to consume, MPC=ΔC/ΔY
 Fraction of extra income that households consume
rather than save
Example
 If MPC = 0.8 and income rises $100, C rises $80.
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A FORMULA FOR THE MULTIPLIER
The size of the multiplier depends on MPC.
E.g., if MPC = 0.5 multiplier = 2
if MPC = 0.75 multiplier = 4
if MPC = 0.9 multiplier = 10
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A bigger MPC means
changes in Y cause bigger
changes in C, which in turn
cause bigger changes in Y.
1
1 – MPC
ΔY = ΔG
The multiplier
OTHER APPLICATIONS OF THE
MULTIPLIER EFFECT
The multiplier effect:
Each $1 increase in G can generate more than a $1
increase in aggregate demand.
Also true for the other components of GDP.
Example: Suppose a recession overseas reduces
demand for U.S. net exports by $10b.
 Initially, aggregate demand falls by $10b.
 The fall in Y causes C to fall, which further
reduces aggregate demand and income.
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2. THE CROWDING-OUT EFFECT
The crowding-out effect
 Offset in aggregate demand
 Results when expansionary fiscal policy raises the
interest rate
 Thereby reduces investment spending
 Which reduces the net increase in aggregate
demand.
 So, the size of the AD shift may be smaller than
the initial fiscal expansion.
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HOW THE CROWDING-OUT EFFECT WORKS
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Y
P
M
Interest
rate
AD1
MS
MD2
MD1
P1
r1
r2
A $20b increase in G initially shifts AD right by $20b
But higher Y increases MD and r, which reduces AD.
AD3
AD2
Y1 Y2
$20 billion
Y3
CHANGES IN TAXES
A tax cut
 Increases households’ take-home pay
 Households respond by spending a portion of
this extra income, shifting AD to the right
 The size of the shift is affected by the multiplier
and crowding-out effects
Another factor: households perception
 Permanent tax cut – large impact on AD
 Temporary tax cut – small impact on AD 28
ACTIVE LEARNING 3 FISCAL POLICY EFFECTS
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
B. If there is crowding out, will Congress need to
increase G more or less than this amount?
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ACTIVE LEARNING 3 ANSWERS
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
 Multiplier = 1/(1 – .8) = 5
 Increase G by $40b
to shift aggregate demand by 5 x $40b
= $200b.
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ACTIVE LEARNING 3 ANSWERS
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
B. If there is crowding out, will Congress need to
increase G more or less than this amount?
 Crowding out reduces the impact of G on AD.
 To offset this, Congress should increase G by a
larger amount.
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THE CASE FOR ACTIVE STABILIZATION POLICY
Keynes: “Animal spirits” cause waves of pessimism and
optimism among households and firms, leading to
shifts in aggregate demand and fluctuations in output
and employment.
Also, other factors cause fluctuations,
 Booms and recessions abroad
 Stock market booms and crashes
If policymakers do nothing
 These fluctuations are destabilizing to businesses,
workers, consumers. 32
THE CASE FOR ACTIVE STABILIZATION POLICY
Proponents of active stabilization policy
 Government should use policy to reduce these
fluctuations:
➢ When GDP falls below its natural rate, use
expansionary monetary or fiscal policy to
prevent or reduce a recession.
➢ When GDP rises above its natural rate, use
contractionary policy to prevent or reduce an
inflationary boom
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THE CASE AGAINST ACTIVE STABILIZATION POLICY
Monetary policy affects economy with a long lag:
 Firms make investment plans in advance,
so I takes time to respond to changes in r
 Most economists believe it takes at least
6 months for monetary policy to affect output
and employment
Fiscal policy also works with a long lag:
 Changes in G and T require acts of Congress.
 Legislative process can take months or years
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THE CASE AGAINST ACTIVE STABILIZATION POLICY
Due to these long lags
 Critics of active policy argue that such policies
may destabilize the economy rather than help it:
 By the time the policies affect aggregate
demand, the economy’s condition may have
changed.
 Contend that policymakers should focus on
long-run goals like economic growth and low
inflation.
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AUTOMATIC STABILIZERS
Automatic stabilizers:
 Changes in fiscal policy that stimulate
aggregate demand when economy goes into
recession
 Without policymakers having to take any
deliberate action
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AUTOMATIC STABILIZERS: EXAMPLES
The tax system
 In recession, taxes fall automatically, which
stimulates aggregate demand
Government spending
 In recession, more people apply for public
assistance (welfare, unemployment insurance)
 Government spending on these programs
automatically rises, which stimulates aggregate
demand
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CONCLUSION
When gvt cuts taxes
 Should consider the short-run effects on
aggregate demand and employment
 And the long-run effects on saving and growth
When the CB reduces the rate of money growth
 Must take into account not only the long-run
effects on inflation
 But the short-run effects on output and
employment
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SUMMARY
• Theory of liquidity preference: the interest rate adjusts
to balance the demand for money with the supply of
money.
• The interest-rate effect helps explain why the
aggregate-demand curve slopes downward:
➢ An increase in the price level raises money demand,
which raises the interest rate, which reduces
investment, which reduces the aggregate quantity of
goods & services demanded.
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SUMMARY
• An increase in the money supply causes the interest
rate to fall, which stimulates investment and shifts the
aggregate demand curve rightward.
• Expansionary fiscal policy—a spending increase or
tax cut—shifts aggregate demand to the right.
Contractionary fiscal policy shifts aggregate demand
to the left.
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SUMMARY
• When the government alters spending or taxes, the
resulting shift in aggregate demand can be larger or
smaller than the fiscal change:
➢ The multiplier effect tends to amplify the effects of
fiscal policy on aggregate demand.
➢ The crowding-out effect tends to dampen the effects
of fiscal policy on aggregate demand.
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SUMMARY
• Economists disagree about how actively policymakers
should try to stabilize the economy.
• Some argue that the government should use
fiscal and monetary policy to combat destabilizing
fluctuations in output and employment.
• Others argue that policy will end up destabilizing the
economy because policies work with long lags.
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