34-1 How Monetary Policy Influences Aggregate Demand

• Three reasons why the aggregate-demand slopes downward:

  • The wealth effect: lower price level raises the real value of household money holdings, part of the wealth

  • The interest-rate effect: lower price level increases people lending out excess money, decreasing the interest rate

  • The exchange-rate effect: when a lower price level reduces the interest rate, funds are moved overseas causing the real value of the domestic currency to fall in the foreign exchange market. Domestic goods become less expensive relative to foreign goods

• The wealth effect is the least important reason for the slope downward. The most important reason for the slope downward is the interest-effect rate

• Theory of liquidity preference: Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance

The Theory of Liquidity Preference

• John Maynard Keynes in The General Theory of Employment, Interest, And Money proposed the theory of liquidity preference to explain the factors that determine the interest rate. It adjusts to balance supply and demand for money.

• The nominal interest rate is usually reported as such, the real interest rate is corrected for inflation.

• Money Supply: The Fed may also influence the money supply by changing how much it lends, altering reserve requirements, and changing charged interest rates on banks.

  • Money supply is represented by a vertical supply curve.

• Money Demand: Money is the most liquid asset. Therefore, it is the most wanted asset (it can buy anything). When you hold material cash (as opposed to a bond or interest-bearing bank account), you don’t earn extra money from it. A decrease in the interest rate reduces the cost of holding money and raises the quantity demanded.

  • Money demand is represented by a sloping downward curve.

• Equilibrium in the Money Market: The equilibrium interest rate, the quantity of money demanded equals the quantity of money supplied. If the interest rate is above or below this level, people will attempt to change how they hold money and drive the interest rate toward the equilibrium

The Downward Slope of the Aggregate-Demand Curve

• The price level is one determinant of the quantity demanded. At higher prices, people will choose to hold more money.

• At a higher interest rate, the cost of borrowing and return to saving are greater.

• A higher price level raises money demand. Higher money demand leads to a higher interest rate. A higher interest rate reduces the quantity of goods and services demanded. The converse is true.

Changes in the Money Supply

• Whenever the quantity of goods and services demanded changes, the aggregate-demand curve shifts.

• Monetary policy is an important value.

• When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the right. The converse is true.

The Role of Interest-Rate Targets in Fed Policy

• Federal funds rate: the interest rate that banks charge one another for short-term loans. The Fed sees this as a target that is reevaluated every 6 weeks.

  • Money supply is hard to measure with precision.

  • Money demand fluctuates over time.

  • The federal funds rate accommodates day-to-day fluctuations

• Monetary policy can be described either in terms of the money supply or in terms of the interest rate.

• Changes in monetary policy aimed at expanding aggregate demand can be described either as increasing the money supply or as lowering the interest rate. Changes in monetary policy aimed at contracting aggregate demand can be described either as decreasing the money supply or as raising the interest rate.

The Zero Lower Bound

• The liquidity trap states that expansionary monetary policy reduces interest rates and stimulates investment spending. But if interest rates have fallen too low, monetary policy is no longer effective.

• The forward guidance policy says that the central bank should commit itself to keep interest rates low for a longer period of time.

• The quantitative easing policy states that the bank reserves should be increased to buy securities and long-term bonds.

34-2 How Fiscal Policy Influences Aggregate Demand

• Fiscal policy: the setting of the levels of government spending and taxation by government policymakers

Changes in Government Purchases

• When policymakers change the money supply or tax level, it indirectly influences the aggregate-demand curve shift. When the government alters its own purchases of goods and services, the demand curve shifts directly.

The Multiplier Effect

• Multiplier effect: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases capital spending

• This is stimulated by the response of investment when there are higher levels of demand.

• The investment accelerator is the positive feedback from demand to investment.

A Formula for the Spending Multiplier

• The marginal propensity to consume (MPC) is the fraction of extra income a household consumes as opposed to saving

• Multiplier = 1/(1 - MPC)

Other Applications of the Multiplier Effect

• Consumption, investment, government purchases, and net exports are also correlated to the multiplier effect

• A small initial change in consumption, investment, government purchases, or net exports can end up having a large effect on aggregate demand and, therefore, the economy’s production of goods and services

The Crowding-Out Effect

• Crowding-out effect: the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate which leads to less investment spending

• When the government increases its purchases by X, the aggregate demand for goods and services could rise by more or less than X depending on the sizes of the multiplier and crowding-out effects.

Changes in Taxes

• The tax change that causes the shift can be larger or smaller (than the shift)

• If a tax cut is viewed as permanent, households will increase their spending by a large amount. If a tax cut is viewed as temporary, households will increase spending by a small amount.

34-3 Using Policy to Stabilize the Economy

The Case for Active Stabilization Policy

• The government can adjust monetary and fiscal policy in response to the market optimism/pessimism, stabilizing the economy.

• When the market is pessimistic, the Fed can expand the money supply to lower interest rates and expand aggregate demand. When they are excessively optimistic, it can contract the money supply to raise interest rates and dampen aggregate demand

The Case Against Active Stabilization Policy

• The economy should deal with short-run fluctuations on its own

• The Fed may be able to stabilize the economy in theory, but not in practice

• The policies affect the economy with a long lag , which means the Fed reacts too late and ends up causing economic fluctuations

• Critics deem passive monetary policy more important.

Automatic Stabilizers

• Automatic Stabilizers: changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession but that occur without policymakers having to take deliberate action

• Automatic tax cuts stimulate aggregate demand and reduce economic fluctuations

• They don’t prevent recessions completely, but still, help reduce the symptoms of the fluctuations