The Influence of Monetary

and Fiscal Policy on

Aggregate Demand
 The Influence of Monetary and Fiscal Policy on
Aggregate Demand
• Monetary policy refers to the control of a country’s quantity of
money by its central bank
• We have discussed the long-run effects of monetary policy
• Fiscal policy refers to the government’s decisions about the
government’s expenditure and taxation
• We have discussed the long-run effects of fiscal policy in the chapter
on Saving, Investment, and the Financial System
• Now we will look at the short-run effects
 Shifts of the Aggregate-Demand Curve

• expansionary fiscal and monetary policy can also shift the AD

curve rightward:
• Consumption:
• Tax cut
• Investment:
• Reduction in interest rates via an increase in the quantity of money
• Cuts in business taxes
• Net Exports: P
• Reduction in the exchange value of the domestic currency via
an increase in the quantity of money

Y
 Aggregate Demand
• When the AD curve shifts, it causes short-run fluctuations
in output and employment.
• Monetary and fiscal policy are sometimes used to offset
those shifts and stabilize the economy.
• This chapter takes a closer look at how monetary
policy and fiscal policy shift the Aggregate Demand
curve.
AGGREGATE DEMAND AND THE INTEREST-RATE
EFFECT
 Recap: The three effects behind Aggregate Demand

• The aggregate demand curve slopes downward for three

reasons:
• The wealth effect:
• The interest-rate effect:
• The exchange-rate effect:

Y
 Recap: The three effects behind Aggregate Demand
• The aggregate demand curve slopes downward for three
reasons:
• The wealth effect: 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.
• The interest-rate effect: 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.
• The exchange-rate effect:
When a lower price level reduces the interest rate, investors move some of their funds overseas
in search of higher returns. 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.P
This change in the real exchange rate stimulates spending on net exports and thus increases the quantity of goods
and services demanded.
Y
 Recap: The three effects behind Aggregate Demand

• The aggregate demand curve slopes downward for three

reasons:
• The wealth effect
The theory of this effect is
• The interest-rate effect called the Theory of
• The exchange-rate effect Liquidity Preference

Y
 The Theory of Liquidity Preference

• John Maynard Keynes developed the theory of liquidity preference

in order to explain what factors influence the interest rate in the
short run.
• According to the theory, the interest rate adjusts to balance the
supply and demand for money.
 Figure 1 Equilibrium in the Money Market

Interest
Rate
Money
supply

0 Quantity fixed Quantity of

by the Fed Money
The Theory of Liquidity Preference: Money Demand

• Money demand is determined by three main factors:

• interest rate↑⇒ money demand ↓
• overall price level↑⇒ money demand↑
• real GDP↑⇒ money demand↑
The Theory of Liquidity Preference: Money Demand

• Money demand is determined by three main factors.

• interest rate↑⇒ money demand ↓
• People choose to hold money instead of other assets that offer higher
rates of return because money can be used to buy goods and services.
• The opportunity cost of holding money is the interest that could be
earned on interest-earning assets.
• An increase in the interest rate raises the opportunity cost of holding
money.
• As a result, the quantity of money demanded decreases.
The Theory of Liquidity Preference: Money Demand

• Money demand is determined by three main factors.

• overall price level↑⇒ money demand↑
• When prices rise people need to keep more cash at hand for
transactions purposes
The Theory of Liquidity Preference: Money Demand

• Money demand is determined by three main factors.

• real GDP↑⇒ money demand↑
• When more output is being produced, more stuff is being bought
• … which is why people will be keeping more money with them
and in their demand deposit accounts.
• This means higher money demand
 P↑, Y↑, r↓ ⇒ Money Demand↑

Interest P2 > P1 Interest Y2 > Y1

Rate Rate

Money demand at Money demand at

r2 r2
price level P2 , MD2 Real GDP Y2 , MD2

r1 r1
Money demand at Money demand at
price level P , MD Real GDP Y , MD
0 0
Quantity Quantity
of Money of Money

Interest
Rate

r2

r1
Money demand, Md

0
Quantity
of Money
 Figure 1 Equilibrium in the Money Market

Interest
Rate
Money
supply

Equilibrium
interest
rate

Money
demand

0 Quantity fixed Quantity of

by the Fed Money
 Figure 1 Equilibrium in the Money Market

Interest
Rate We have just seen that
the demand for money
Money
increases if the price
supply
level (P) or real output
(Y) increases.
Q: How would an
increase in P affect the
interest rate?
Equilibrium
interest
rate

Money
demand

0 Quantity fixed Quantity of

by the Fed Money
 Figure 2 The Money Market and the Slope of the
Aggregate-Demand Curve

(a) The Money Market (b) The Aggregate-Demand Curve

Interest Money Price

Rate supply Level
2. . . . increases the
demand for money . . .

r2 P2
Money demand at
price level P2 , MD2
r 1. An P
3. . . .
which increase
Money demand at in the Aggregate
increases
price level P , MD price demand
the
equilibrium 0 level . . . 0
Quantity fixed Quantity Y2 Y Quantity
interest
by the Fed of Money of Output
rate . . .
4. . . . which in turn reduces the quantity
of goods and services demanded.
The Downward Slope of the Aggregate Demand Curve: interest
rate effect
• Overall price level (P)↑⇒ money demand↑
• Higher money demand leads to a higher interest rate.
• At a higher interest rate the quantity of goods and services
demanded falls.
• interest rate↑⇒ investment spending by businesses ( I)↓
• even consumption spending (C) may ↓
• Therefore, P↑⇒ C + I + G + NX ↓
MONETARY POLICY, EXPANSIONARY AND
CONTRACTIONARY
Changes in the Money Supply

• The Fed can shift the aggregate demand curve when it

changes its monetary policy.
• An increase in the money supply shifts the money supply
curve to the right.
• The interest rate falls.
• Falling interest rates increase the quantity of goods and
services demanded.
 Expansionary Monetary Policy

Interest
Rate
Money
supply Note that
expansionary
monetary policy can
be described as an
increase in the
money supply or as a
cut in interest rates
r1

r2
Money
demand

0 Quantity of
Money
 Figure 3 Expansionary Monetary Policy

(a) The Money Market (b) The Aggregate-Demand Curve

Interest Price
Rate Money MS2 Level
supply,
MS

r 1. When the Fed P

increases the
money supply . . .
2. . . . the r2
AD2
equilibrium
interest rate Money demand Aggregate
falls . . . at price level P demand, AD
0 Quantity 0 Y1 Y2 Quantity
of Money of Output

3. . . . which increases the quantity of goods

and services demanded at a given price level.
M↑⇒r↓⇒I↑⇒C + I + G + NX↑
⇒ AD curve shifts right
And when M↓, the reverse happens
 Expansionary Monetary Policy: Criticisms
This shows that In extreme cases, if
Interest expansionary the interest rate
Rate
monetary policy is reaches the zero
less successful in Money lower bound,
reducing interest supply expansionary
rates when money monetary policy
demand is flatter would no longer
work

r1
r3
r2
Money
demand

0 Quantity of
Money
 Crisis of 2008: monetary stimulus
• The Federal Reserve did all it could
• But the Federal Funds Rate could not be reduced below zero!
 Expansionary Monetary Policy: Criticisms
• Critics of expansionary monetary policy have also argued that
even if an increase in the money supply succeeds in reducing
the interest rate, the fall in the interest rate may not lead to an
increase in investment spending by businesses (I)
• Why? Business investment spending is heavily influenced by
optimism or pessimism; interest rates play a minor role
FISCAL POLICY
 HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND

• Fiscal policy refers to the government’s choices regarding

• government purchases (G) and
• taxes (T).
• Fiscal policy influences saving, investment, and growth in
the long run.
• In the short run, fiscal policy primarily affects the aggregate
demand.
 Fiscal policy: expansionary and contractionary
• Expansionary fiscal policy: G↑ or T↓
• Decreases government saving T – G
• Contractionary fiscal policy: G↓ or T↑
• Also called “fiscal austerity” or “belt tightening”
• Increases government saving T – G
Changes in Government Purchases

• There are two important macroeconomic consequences of

a change in government purchases:
• The multiplier effect
• The crowding-out effect
The Multiplier Effect

• Government purchases are said to have a multiplier effect

on aggregate demand.
• Each dollar spent by the government may raise the aggregate
demand for goods and services by more than a dollar.
• Government spending increases income and thereby increases
consumer spending which leads to further increases in income.
• G↑⇒ aggregate demand↑⇒Y↑⇒C↑⇒ aggregate demand ↑ ⇒ Y↑
⇒ C↑⇒Y↑⇒C↑⇒Y↑⇒C↑⇒Y↑⇒C↑…
 Figure 4 The Multiplier Effect
Price
Level

2. . . . but the multiplier

effect can amplify the
shift in aggregate
demand.

$20 billion

AD3
AD2
Aggregate demand, AD1
0 Quantity of
1. An increase in government purchases Output
of $20 billion initially increases aggregate
demand by $20 billion . . .
A Formula for the Spending Multiplier

• The formula for the spending multiplier is:

Multiplier = 1/(1 – MPC)
• An important number in this formula is the marginal propensity to
consume (MPC).
• The MPC is the fraction of every additional dollar of income that
a household spends on domestic goods and services
• The bigger the MPC, the bigger the spending multiplier
• That is, the more people love to spend, the more effective
government spending is in increasing production and
employment
A Formula for the Spending Multiplier

• If the MPC is 3/4, then the multiplier will be:

Multiplier = 1/(1 - 3/4) = 4
• In this case, a $20 billion increase in government spending
generates $80 billion of increased demand for goods and
services.
• If the MPC is 9/10, then the multiplier will be:
Multiplier = 1/(1 - 9/10) = 10
• In this case, a $20 billion increase in government spending
generates $200 billion of increased demand for goods and
services
The Crowding-Out Effect

• On the negative side, government spending may not affect

the economy as strongly as predicted by the multiplier.
• An increase in government purchases causes GDP to
increase (as indicated by the multiplier effect)
• This increases the demand for money.
• The liquidity preference theory argues that people wish to carry
more money when incomes increase because of increased
shopping
• This causes lending to fall and the interest rate to rise.
• A higher interest rate reduces investment spending and,
 Figure 5 The Crowding-Out Effect

(a) The Money Market (b) The Shift in Aggregate Demand

Interest Price
Money 4. . . . which in turn
Rate Level
supply partly offsets the
2. . . . the increase in $20 billion initial increase in
spending increases aggregate demand.
money demand . . .
r2

3. . . . which
increases AD2
the r
AD3
equilibrium M D2
interest
rate . . . Aggregate demand, AD1
Money demand, MD
0 Quantity fixed Quantity 0 Quantity
by the Fed of Money 1. When an increase in government of Output
purchases increases aggregate
demand . . .
The Crowding-Out Effect

• When the government increases its purchases by $20

billion, the aggregate demand for goods and services could
rise by more or less than $20 billion, depending on whether
the multiplier effect or the crowding-out effect is larger.
Changes in Taxes

• When the government cuts personal income taxes, it

increases households’ take-home pay.
• Households save some of this additional income.
• Households also spend some of the tax cut on consumer goods.
• Increased consumption spending shifts the aggregate-demand
curve to the right.
Changes in Taxes

• The size of a tax cut’s impact on aggregate demand

depends, once again, on the multiplier and crowding-out
effects.

• The impact of a tax cut also depends on households’

perceptions about the permanence of the tax change.
 Tax cuts: temporary v. permanent
• The effect of a tax cut on aggregate demand is also affected by
households’ perceptions about the permanence of the tax
change.
• If the tax cut is perceived to be temporary, most of the tax cut
will be saved rather than spent
• Therefore, a temporary tax cut will not boost aggregate demand
very much
STABILIZATION POLICY: FOR AND AGAINST
 USING POLICY TO STABILIZE THE ECONOMY
• The efforts of the government to increase aggregate
demand during a recession are called stabilization policy
• Economic stabilization has been an explicit goal of U.S.
policy since the Employment Act of 1946.
• This act states that “it is the continuing policy and
responsibility of the federal government to … promote full
employment and production.”
The Case for Active Stabilization Policy

• The Employment Act has two implications:

• The government should avoid being the cause of economic
fluctuations.
• The government should respond to changes in the private
economy in order to stabilize aggregate demand.
• If private-sector activity pushes aggregate demand to the left (thereby
causing a recession), the government should do what it can to push
aggregate demand to the right (thereby ending the recession)
 The Case For Active Stabilization Policy
• What is the evidence that stabilization policy works?
• The large increases in public spending in the US after WWII are
widely regarded as having played a crucial role in rescuing the
economy from the Great Depression
• Key point: if the private sector refuses to spend, the government
becomes the spender of last resort
• Similarly, the large tax cuts during the (short-lived) Kennedy
administration are also widely regarded as having led to rapid
growth
59
 The Case Against Active Stabilization Policy
• Some economists argue that monetary and fiscal policy
destabilizes the economy.
• Why?
• Because monetary and fiscal policy affect the economy with a
substantial lag.
• These lagged (or mistimed) effects destabilize the economy
instead of stabilizing it.
• Therefore, opponents of stabilization policy say that the
economy should be left to deal with the short-run fluctuations
on its own.
The Case Against Active Stabilization Policy

• Most economists believe that it takes at least six months

for monetary policy to affect output and employment.
• And these effects can then last for several years.
• Economic forecasting is very imprecise. It is difficult to
implement monetary policy six months before a recession.
• When monetary policy reacts late, the AD curve may shift
right after the economy has already recovered.
• This would destabilize the economy.
The Case Against Active Stabilization Policy

• The lags that reduce the effectiveness of fiscal policy are

largely due to the sluggishness of the political process
 Budget deficits and the national debt
• Recall that expansionary fiscal policy leads to an increase in
government borrowing (budget deficit)
• If a government keeps borrowing year after year, its debt
accumulates
• As the government’s debt accumulates, lenders may start to
worry about the possibility of default …
 Budget deficits and the national debt
• As a result, the interest rate the government has to pay may rise
• This rise in the interest rate may further increase the probability
of default
• As a result, the interest rate the government has to pay may rise
again
• This rise in the interest rate may increase the probability of
default yet again
• And so on and on …
 Budget deficits and the national debt
• At some point, the first flickers of suspicion among lenders may
turn into a self-fulfilling prophecy, and default may become
inevitable
• This is especially the case when the interest rate the
government has to pay exceeds the rate of growth of the
economy’s income
• A country with low government debt has a lot of room to use
fiscal stimulus to fight a recession
 The Balanced Budget Multiplier
• In theory, it is possible to use expansionary fiscal policy without
any additional borrowing by the government!
• Suppose both government spending and taxes rise by $800
billion
• No additional borrowing would be necessary
• And yet, aggregate demand would increase.
• (Why?)
 The balanced budget multiplier
• If $800 billion fell from the sky, people would spend part of it
(say, $700 billion) and save the rest ($100 billion)
• By reverse reasoning, if the government took away $800 billion
in taxes, spending by taxpayers would fall by $700 billion
• But, the government’s spending would rise by $800 billion
• Therefore, on balance, the country’s total spending would rise
by $100 billion
 The balanced budget multiplier
• In this way, the balanced budget expansion of both government
spending and taxes, increases the aggregate demand for
domestic goods and services without any increase in
government borrowing!
Automatic Stabilizers

• We have seen that expansionary fiscal policy has various

lags that make it less effective in stabilization
• A way to avoid the lags problem is to use automatic
stabilizers
• Automatic stabilizers are changes in fiscal policy that
stimulate aggregate demand when the economy goes into
a recession without policymakers having to do anything.
• Examples of automatic stabilizers include a progressive tax
system and means-tested forms of government spending.
 Automatic Stabilizers
• When incomes decrease, so do the government’s tax
revenues. This automatic tax cut boosts aggregate
demand just when such a boost is most needed
• Government spending on unemployment insurance,
welfare benefits, and other forms of income support also
act as automatic stabilizers
• Unfortunately, these automatic stabilizers are not always
sufficiently strong and, therefore, policy makers may still
need to enact stabilization policies
Automatic Stabilizers: Balanced Budget Amendment
• We have seen before that during a recession, incomes decrease
and the government’s tax revenues also decrease
• Under a balanced budget amendment, the fall in tax revenues
would force the government to cut government spending
• A reduction in government spending during a recession would
be highly inappropriate.
• For this reason, economists are opposed to a balanced budget
amendment
• However, keeping the budget balanced in the long run may be a
good idea
 Summary
• Keynes proposed the theory of liquidity preference to
explain determinants of the interest rate.
• According to this theory, the interest rate adjusts to balance
the supply and demand for money.
 Summary
• An increase in the price level raises money demand and
increases the interest rate.
• A higher interest rate reduces investment and, thereby, the
quantity of goods and services demanded.
• The downward-sloping aggregate-demand curve
expresses this negative relationship between the price-
level and the quantity demanded.
 Summary
• Policymakers can influence aggregate demand with
monetary policy.
• An increase in the money supply will ultimately lead to the
aggregate-demand curve shifting to the right.
• A decrease in the money supply will ultimately lead to the
aggregate-demand curve shifting to the left.
 Summary
• Policymakers can influence aggregate demand with fiscal
policy.
• An increase in government purchases or a cut in taxes
shifts the aggregate-demand curve to the right.
• A decrease in government purchases or an increase in
taxes shifts the aggregate-demand curve to the left.
 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.
 Summary
• Because monetary and fiscal policy can influence
aggregate demand, the government sometimes uses these
policy instruments in an attempt to stabilize the economy.
• Economists disagree about how active the government
should be in this effort.
• Advocates say that if the government does not respond the
result will be undesirable fluctuations.
• Critics argue that attempts at stabilization often turn out
destabilizing.