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Chapter 34

The Influence of Monetary and Fiscal

Policy on Aggregate Demand
 Effects of Monetary and Fiscal Policy on
Aggregate Demand (AD)
Besides monetary and fiscal policy, there are many factors that affect
aggregate demand.
- Especially expenditures of households and firms
determine overall demand for goods and services.
- The change of these expenditures shift AD curve,
which leads to fluctuations of production and
employment in the short run.
Monetary and fiscal policy are used not only to stimulate the
economy but also to stabilize imbalances of the economy caused by
the shift of AD curve.
 Aggregate-Demand Curve
According to the classical theory, there are three reasons why
AD curve slopes downward:
– Simultaneously:
• The wealth effect
• The interest-rate effect
• The exchange-rate effect
– When price level falls, quantity of goods and services demanded
increases.
• While price level rises, quantity of goods and services demanded
decreases.
 Aggregate-Demand Curve
For the U.S. economy
– The wealth effect is least important
• Money holdings are a small part of household wealth
– The exchange-rate effect is not large
• Exports and imports are small fraction of GDP
– The interest-rate effect
• The most important
For the Korean economy
– The exchange-rate effect is large.
• Exports and imports are large fraction of GDP.
 Theory of Liquidity Preference
Keynes’s theory that is suitable for explaining the
factors that determine an economy’s short-run
interest rate
–Theory which says that interest rate is determined by
money demand and money supply
–Interest rate adjusts to bring money demand and supply into
balance
※An asset’s liquidity is the ease with which that
asset can be converted into the economy’s
medium of exchange (money).
 Theory of Liquidity Preference
Theory of liquidity preference is a theory of money
demand because money is the economy’s medium
of exchange by itself.
Motives for money holding according to Keynes
- Transaction motive: function of income (Y)
- Precautionary motive: function of income (Y)
- Speculative motive: function of interest rate (r)
money holding for purchase of bonds

Md = L(Y, r)
 Theory of Liquidity Preference
Key points: This theory is relevant for the following 1 and 2
1. Money demand for transaction motive increases if
price level increases.
2. Interest rate increases due to decrease of saving as
money demand for transaction motive increases.
3. Decrease of aggregate demand (such as consumption
and investment) as interest rate increases
⇒Draw of downward slopping AD curve because AD decreases
if price level increases
※usefulness:·explains why AD curve slopes downward
·valuable when analyzing effects of monetary and fiscal
policy on AD
 Supply of Money
Money supply is an exogenous variable
– Controlled by a central bank
– Quantity of money supplied
• Fixed by a central bank and doesn’t vary with interest rate
– A central bank alters the money supply using mainly
• Open-market operations: purchase and sale of government bonds
• Reserve requirements: changing the quantity of reserves in the
banking system
Supply of money is vertical because it is fixed by a central
bank.
 Demand for Money
According to theory of liquidity preference, interest
rate is the most important factor that affects
money demand.
- Money is a medium of exchange and an asset
without any profit.
- As interest rate rises, opportunity cost of
holding money increases, which reduces demand
for money
⇒Inverse relationship between money demand and
interest rate
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Figure 1 Equilibrium in the Money Market

Interest Money supply
rate

r1
Equilibrium
Interest rate
r2

Money
demand
Quantity Md2 Quantity of Money
Fixed by the Fed
According to the theory of liquidity preference, the interest rate adjusts to bring the quantity of money
supplied and the quantity of money demanded into balance. If the interest rate is above the equilibrium
level (such as at r1), the quantity of money people want to hold (Md1) is less than the quantity the Fed has
created, and this surplus of money puts downward pressure on the interest rate. Conversely, if the interest
rate is below the equilibrium level (such as at r2), the quantity of money people want to hold (Md2) is
greater than the quantity the Fed has created, and this shortage 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.
 Figure 2 The Money Market and the Slope of the
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Aggregate-Demand Curve
(a) The Money Market (b) The Aggregate-Demand Curve
Interest Price
rate Money 2. . . . increases the level 1. An increase in the price level . . .
supply demand for money . . .
4. . . . which in turn
3. . . . which increases reduces the quantity
equilibrium interest rate . . . P of goods and
r2 2 services demanded.

r1 Money demand at
price level P2, MD2 P1

Money demand at Aggregate

price level P1, MD1 demand

0 Quantity fixed Quantity 0 Y2 Y1 Quantity

by the Fed of money of output

An increase in price level from P1 to P2 shifts money-demand curve to the right, as in panel (a). This increase in
money demand causes the interest rate to rise from r 1 to r2. Because the interest rate is the cost of borrowing, the
increase in the interest rate reduces the quantity of goods and services demanded from Y 1 to Y2. This negative
relationship between the price level and quantity demanded is represented with a downward-sloping aggregate-
demand curve, as in panel (b).
 Draw of Aggregate-Demand Curve
①As price level rises, amount of money that people
want to hold for transaction increases
Price↑⇒money demand for transaction motive↑
②increase of interest rate due to the shift of money
demand curve to the right
Excessive demand for money at a given interest
rate⇒saving↓, sale of bonds↑⇒price of bonds↓
⇒interest rate↑
③I↓, C↓, S↑⇒aggregate demand↓
 Changes in the Money Supply:
Monetary Policy
Changes in monetary policy aimed at expanding
aggregate demand
– Increasing the money supply
– Lowering the interest rate
Changes in monetary policy aimed at contracting
aggregate demand
– Decreasing the money supply
– Raising the interest rate
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Figure 3 A Monetary Injection

Interest (a) The Money Market Price (b) The Aggregate-Demand Curve
rate level
Money supply,
MS1 MS2
1. When the Fed
increases the
r1 money supply . . .
P

r2

AD2
Money demand Aggregate
at price level P demand, AD1
0 Quantity 0 Y1 Y2 Quantity of output
2. . . . the equilibrium of money 3. . . . which increases the quantity of goods
interest rate falls . . . and services demanded at a given price level.

In panel (a), an increase in the money supply from MS 1 to MS2 reduces the equilibrium
interest rate from r1 to r2. 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 from
Y1 to Y2. Thus, in panel (b), the aggregate-demand curve shifts to the right from AD 1 to AD2.
 Changes in the Money Supply:
Monetary Policy
Monetary policy shifts AD curve
Central banks can influence aggregate demand by changing
money supply (eg.: Abenomics, Quantitative Easing)
Increase of money supply causes interest rate to fall in the given
money demand curve.
Fall of interest rate shifts AD curve to the right because demand
for goods and service rises at a given price level.

Ms↑⇒excessive supply of money⇒C↑, S↑, purchase of bonds

↑ ⇒price of bonds↑⇒ r↓⇒I↑, C↑⇒shift of AD curve to the right
 Role of Interest-Rate Targets
Policy instruments of a central bank are the money supply and
the interest rate.
A central bank can change the money supply or the interest rate
as its target.
Monetary policy can be described either in terms of the money
supply or in terms of the interest rate: result is the same.
Bank of Korea influences the benchmark interest rate as its
target, which affects the money market and subsequently
aggregate demand.
※money supply↑⇒interest rate↓
money supply↓⇒interest rate↑
 Liquidity Trap
Liquidity trap
– If interest rates have already fallen to around zero
– Monetary policy may no longer be effective
– Aggregate demand, production, and employment may
be "trapped" at low levels.
 Fiscal Policy and Aggregate Demand
Instruments of fiscal policy are changes in
government spending and tax.
Fiscal policy such as tax cut influences economic
growth in the long run by affecting saving and
investment.
Fiscal policy such as changes in government
spending influences aggregate demand in the short
run.
 Changes in Government Purchases
Changes in money supply and tax affect decision making
of households and firms indirectly.
Changes in government purchases of goods and services
affect AD curve directly.
Government policymakers
– Set the level of government spending and taxation
Changes of government purchases have two effects
 multiplier effect
 crowding-out effect
The final effect of changes in government purchases on
AD depends on which of these effects is dominant
 Fiscal Policy and Aggregate Demand
The multiplier effect
– Additional shifts in aggregate demand
• Result when expansionary fiscal policy increases income
• And subsequently increases consumer spending
The multiplier effect of an increase in government purchases
by $20 billion
– AD curve
• Shifts right by exactly $20 billion
– Consumers respond
• Increase spending
– AD curve
• Shifts right further
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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

1. An increase in government purchases Quantity of

of $20 billion initially increases aggregate Output
demand by $20 billion . . .

An increase in government purchases of $20 billion can shift the

aggregate-demand curve to the right by more than $20 billion. This
multiplier effect arises because increases in aggregate income
stimulate additional spending by consumers.
 Spending Multiplier
• Spending multiplier
multiplier=1/(1-MPC)

– Marginal propensity to consume (MPC)

•Fraction of extra income that consumers spend
– Size of the spending multiplier
•Depends on the MPC
– The larger MPC is, the larger the multiplier
•If MPC=3/4, spending multiplier=1/(1-3/4)=4
•If MPC=9/10, spending multiplier=1/(1-9/10)=10
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Fiscal Policy Influences AD

Spending multiplier = 1/(1 – MPC)

=1/(1-MPC)

- If MPC=3/4, spending multiplier=1/(1-3/4)=4

- If MPC=9/10, spending multiplier=1/(1-9/10)=10
 Crowing-out Effect
It is an offset effect in aggregate demand
– Results when expansionary fiscal policy raises the interest rate and
thereby reduces investment spending
• Increase in income
• Money demand increases and interest rate increases
• AD curve shifts left
G↑⇒AD↑⇒Income↑⇒ Md for transaction motive↑⇒r↑⇒I↓
The crowing-out effect is an offset effect caused by investment fall
resulting from increase of interest rate.
In an extreme case of full crowing-out, AD curve can not shift if
interest rate rises a lot and firms respond sensitively to interest rate.
※The classical school criticizes the New Deal Policy for the low multiplier effect due to high
crowding-out effect.
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Figure 5 The Crowding-Out Effect

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

Interest
rate 2. . . . the increase in Price 1. When an increase in
Money
spending increases level government purchases
supply
money demand . . . increases aggregate demand…

3. . . . which increases the $20 billion

r2 equilibrium interest rate . . .

r1
MD2
AD2
AD3
Money demand, MD1 Aggregate demand, AD1
0 Quantity fixed Quantity 4. . . 0which in turn partly offsets the Quantity
by the Fed of money initial increase in aggregate demand. of output

Panel (a) shows the money market. When the government increases its purchases of goods and services,
the resulting increase in income raises the demand for money from MD1 to MD2, and this causes the
equilibrium interest rate to rise from r1 to r2. Panel (b) shows the effects on AD. The initial impact of the
increase in government purchases shifts the AD curve from AD1 to AD2. 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 investment partially offsets the
impact of the fiscal expansion on AD. In the end, the AD curve shifts only to AD3.
 Changes in Taxes
A decrease in personal income taxes
– Households income increases
– Multiplier effect: AD increases
– Crowding-out effect: AD decreases
Impact of tax cut on AD depends on the perception of
households of whether it is temporary or permanent.
 Permanent Income Hypothesis (Milton Friedman):
Consumption is determined not by the current income
but by the life-time income
– Permanent tax cut – large impact on AD
– Temporary tax cut – small impact on AD
 Using Stabilization Policy
Keynes: for active stabilization policy
– Key role of AD in explaining short-run economic fluctuations
– The government should actively stimulate AD
• When AD appeared insufficient to maintain production at its full-
employment level
– Keynes and his followers argue that AD fluctuations in the
short run result largely from irrational waves of pessimism
and optimism of people.
• Forecasting of people on economy has the characteristic of self-
fulfilling prophesy.
• Therefore, government should conduct discretionary stabilization
policy using government spending and tax instrument
 Using Stabilization Policy
Monetarist: against active stabilization policy
– Government
• Should avoid active use of monetary and fiscal policy to try to stabilize
the economy because they affect the economy with a time lag.
– Policy instruments
• Should be set to achieve long-run goals
– They argue that the economy should be left alone to deal with
short-run fluctuations so that the problems can be solved by self-
healing ability of the economy
– Especially, fiscal policy can expand the fluctuations due to the
big time lag from planning to implementation
• Fine tuning of the fluctuations might be impossible
 Automatic Stabilizers (Built-in
Automatic stabilizers Stabilizers)
– Changes in fiscal policy
• That stimulate AD (or break AD)
• When the economy goes into a recession (an excessive boom)
– Without policymakers having to take any deliberate action
– Examples:
• The progressive income tax system
• Benefits of social security: increase of public assistance in a recession,
while decrease of it in a boom
• Unemployment insurance:
- boom: accumulation of fund and decrease of benefits
- recession: decrease of fund and increase of benefits
(in reality?)