Chapter 32

Influence of Monetary & Fiscal

Policy on Aggregate Demand
 How Monetary Policy Influences
Aggregate Demand
Remember: AD slopes downward b/c of
wealth effect, interest rate effect & exchange
rate effect
All 3 effects occur simultaneously, but interest
rate effect is most important
 Theory of Liquidity Preference
Keyness theory that the interest rate adjusts
to bring money supply and money demand
into balance
- we assume nominal & real interest rates
move together
 Money Supply
Is controlled by Federal Reserve
Because Fed controls it w/o regard to other
econ. Variables; its represented with vertical
supply curve
 Money Demand
Liquidity how easy asset can be converted
into medium of exchange ($ is most liquid)
As interest rate rises, the quantity of money
demanded falls downward sloping demand
Interest rate adjusts to bring money demand
and money supply into balance
 Downward Slope of AD Curve
When PL increases, people demand more $,
this shifts money demand curve to the right
With fixed money supply, interest rate must
rise
 With higher interest rate, return on saving
increase so consumers more likely to save and
less likely to invest in new housing
Therefore, Q of goods & services will fall;
basically explaining interest rate effect
 Changes in Money Supply
Fed buys bonds in open market operations
will increase supply of money; shifts money
supply to right, interest rate falls & AD shifts
right
 Interest Rate Targets
Monetary policy can be described either in
terms of the money supply or the interest rate
Fed sometimes targets a specific federal funds
rate (interest rate for banks) rather than a
certain money supply
 The Fed & The Stock Market
Fed will try to stabilize economy by lowering
interest rates when stock market is down and
by raising interest rates when stock market is
soaring
 Fiscal Policy & Aggregate Demand
By changing taxing & spending, it shifts AD
directly
How much a change in govt purchases
increases AD is based on Multiplier effect &
Crowding Out effect
 Fiscal Policy Influences Aggregate Demand
Primary effect of fiscal policy in the short run is on
AD
If Fed changes money supply, they influence
spending decisions of firms and households and
thereby INDIRECTLY affect AD
If Govt. changes tax rates, they influence the
spending decisions of firms and households and
thereby INDIRECTLY affect AD
If Govt. changes its own spending, it DIRECTLY affects
AD
If the Govt. increases spending by $20 billion
dollars, how far does AD shift? To what extent
does GDP increase?

The Multiplier Effect suggests that .

The shift in AD could be larger than the change

in Govt. spending (larger than $20 b)
 GDP
+$20
Increase
Electronics Consumer
Increase
Industry.
Consumer
Spending
hires more
Spending/
Boeing
increases Electronics
employment/
income

G buys $20 from Boeing

 Spending Multiplier
MPC
Fraction of extra income that a household
consumes rather than saves
If MPC = .80..it means that.
For every extra dollar of income the
household earns,
the household will spend 0.80and
save 0.20
 If MPC is 0.80, then MPS is ..
0.20
If Govt. spends $20bthen that is extra income
for Boeing and they will spend.
$16 b and save $4b..
and that spending is an extra $16b income for
others, of that they will spend..
$12.8 b and save $3.2 b.
And that spending is an extra $12.8b income for
others, of that they will spend..
$10.24 b and save $2.56b..and so on and on.
 So the multiplier is 1 / (1-MPC) . or .
1/MPS
so the original $20 b of increased govt.
spending could generate a total of
$100 b ..how?
$20 b initial increase x 1/.20 .
$20 b x 5 = $100 b
COULD?????? Why the word could ?
 MPC = .80
What if the govt. purchased $20 b from
Boeing, but instead of expanding production
and labor force, they simply put the $20 b in
savings.?
The Multiplier is now 1 and the impact on the
GDP is and increase of only $20 instead of
$100..
What if they spent $10b of the $20.?
 The larger the MPC, the ..
Larger the Multiplier..Explain
 Logic of multiplier applies to any component
of AD and GDP
A small initial change in (C or I or G or Nx)
Can result in a multiplied effect on AD and
GDP
 Change in Taxes
When the Govt. increase or decrease taxthe
multiplier is applied to the change in spending
but must figure out what the change in
spending will be.
If the govt. cuts tax by $10, it increases DI by
$10..but..
DI is not a part of AD (C,I,G,Nx) ..so..
a $10 tax cut will increase C by
Tax x MPC logic
 If you now have $10 extra, you will not spend
all of it, but rather you will spend a % of the
additional income based on MPC.so..
Tax cut $10 = increase C by ($10 x MPC .80) =
$8 and increase savings by $2
Now can apply multiplier to increase in
amount of C , and NOT the size of the tax
 If MPC = .80
Tax cut $10 =
Increase DI $10=
Increase C $8
Increase GDP $40
Crowding Out Effect
 Crowding Out Effect
If govt uses fiscal policy to expand (lowers
taxes, increases spending) it will have
multiplier effect on AD, but it also will cause
interest rate to rise
This rise in interest rate will decrease
investment, which lowers AD thereby
crowding out some of the growth (govt
spending crowds out investment spending)
Crowding Out
G increase spending
AD shifts rt.

money market
MD shifts right
IR rise
Inv. Decreases
AD shifts left
G = AD shift right
But also causes IR to rise and lowers Inv and AD

As G increases spending, the resulting increase in IR

CROWDS OUT Investment and prevents AD
from expanding as much as intended.

Can PREVENT expansionary fiscal policy from

reaching its goal.
 Consider Crowding In effect
Nx effect