367
WHAT’S NEW IN THE SEVENTH EDITION:
There are no major changes to this chapter.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ the theory of liquidity preference as a short-run theory of the interest rate.
➢ how monetary policy affects interest rates and aggregate demand.
➢ how fiscal policy affects interest rates and aggregate demand.
➢ the debate over whether policymakers should try to stabilize the economy.
CONTEXT AND PURPOSE:
Chapter 21 is the second chapter in a three-chapter sequence that concentrates on short-run fluctuations
in the economy around its long-term trend. In Chapter 20, the model of aggregate supply and aggregate
demand is introduced. In Chapter 21, we see how the government’s monetary and fiscal policies affect
aggregate demand. In Chapter 22, we will see some of the trade-offs between short-run and long-run
objectives when we address the relationship between inflation and unemployment.
KEY POINTS:
• In developing a theory of short-run economic fluctuations, Keynes proposed the theory of liquidity
preference to explain the determinants of the interest rate. According to this theory, the interest rate
adjusts to balance the supply and demand for money.
• An increase in the price level raises money demand and increases the interest rate that brings the
money market into equilibrium. Because the interest rate represents the cost of borrowing, a higher
21
THE INFLUENCE OF
MONETARY AND FISCAL
POLICY ON AGGREGATE
DEMAND
368 ❖ Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand
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.
• Policymakers can also 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.
• 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.
• 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. According to the advocates of active stabilization
policy, changes in attitudes by households and firms shift aggregate demand; if the government does
not respond, the result is undesirable and unnecessary fluctuations in output and employment.
According to critics of active stabilization policy, monetary and fiscal policy work with such long lags
that attempts at stabilizing the economy often end up being destabilizing.
CHAPTER OUTLINE:
I. How Monetary Policy Influences Aggregate Demand
A. The aggregate-demand curve is downward sloping for three reasons.
1. The wealth effect.
2. The interest-rate effect.
3. The exchange-rate effect.
B. All three effects occur simultaneously, but are not of equal importance.
The effects of monetary policy are easy to show graphically. Begin with money
supply, money demand, and an equilibrium interest rate. Show how both an increase
and a decrease in the money supply affect interest rates.
Students are very interested in the way in which the Fed changes interest rates.
Review what they learned about the Fed and its tools to change the money supply.
Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand ❖ 369
1. Because a household’s money holdings are a small part of total wealth, the wealth effect is
the least important of the three.
C. Definition of theory of liquidity preference: Keynes’s theory that the interest rate
adjusts to bring money supply and money demand into balance.
D. The Theory of Liquidity Preference
1. This theory is an explanation of the supply and demand for money and how they relate to
the interest rate.
2. Money Supply
a. The money supply in the economy is controlled by the Federal Reserve.
b. The Fed can alter the supply of money using open market operations, changes in the
discount rate, and changes in reserve requirements.
c. Because the Fed can control the size of the money supply directly, the quantity of money
supplied does not depend on any other economic variables, including the interest rate.
Thus, the supply of money is represented by a vertical supply curve.
Figure 1
Point out that when we discuss the “interest rate” we are discussing both the
nominal interest rate and the real interest rate because we are assuming that they
will move together. Remind the students of the Fisher equation.
370 ❖ Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand
3. Money Demand
a. Any asset’s liquidity refers to the ease with which that asset can be converted into a
medium of exchange. Thus, money is the most liquid asset in the economy.
4. Equilibrium in the Money Market
a. The interest rate adjusts to bring money demand and money supply into balance.
b. If the interest rate is higher than the equilibrium interest rate, the quantity of money that
people want to hold is less than the quantity that the Fed has supplied. Thus, people will
try to buy bonds or deposit funds in an interest-bearing account. This increases the funds
available for lending, pushing interest rates down.
c. If the interest rate is lower than the equilibrium interest rate, the quantity of money that
people want to hold is greater than the quantity that the Fed has supplied. Thus, people
will try to sell bonds or withdraw funds from an interest-bearing account. This decreases
the funds available for lending, pulling interest rates up.
E.
FYI: Interest Rates in the Long Run and the Short Run
1. In an earlier chapter, we said that the interest rate adjusts to balance the supply and
demand for loanable funds.
2. In this chapter, we proposed that the interest rate adjusts to balance the supply and demand
for money.
3. To understand how these two statements can both be true, we must discuss the difference
between the short run and the long run.
4. In the long run, the economy’s level of output, the interest rate, and the price level are
determined by the following manner:
a.
Output
is determined by the levels of resources and technology available.
5. In the short run, the economy’s level of output, the interest rate, and the price level are
determined by the following manner:
Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand ❖ 371
a. The
price level
is stuck at some level (based on previously formed expectations) and is
unresponsive to changes in economic conditions.
F. The Downward Slope of the Aggregate-Demand Curve
1. When the price level increases, the quantity of money that people need to hold becomes
larger. Thus, an increase in the price level leads to an increase in the demand for money,
shifting the money demand curve to the right.
2. For a fixed money supply, the interest rate must rise to balance the supply and demand for
money.
3. At a higher interest rate, the cost of borrowing and the return on saving both increase. Thus,
consumers will choose to spend less and will be less likely to invest in new housing. Firms will
be less likely to borrow funds for new equipment or structures. In short, the quantity of
goods and services purchased in the economy will fall.
4. As the price level increases, the quantity of goods and services demanded falls. This is
Keynes’s interest-rate effect.
G. Changes in the Money Supply
Figure 2
Go through the example above in reverse as well. Make sure that students
understand that a decline in the price level will lead to a drop in money demand and
the interest rate and that this will cause a rise in aggregate quantity demanded.
372 ❖ Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand
2. This will increase the supply of money, shifting the money supply curve to the right. The
equilibrium interest rate will fall.
3. The lower interest rate reduces the cost of borrowing and the return to saving. This
encourages households to increase their consumption and desire to invest in new housing.
Firms will also increase investment, building new factories and purchasing new equipment.
4. The quantity of goods and services demanded will rise at every price level, shifting the
aggregate-demand curve to the right.
5. Thus, a monetary injection by the Fed increases the money supply, leading to a lower
interest rate, and a larger quantity of goods and services demanded.
Figure 3
Point out the circumstances under which the Fed is likely to increase the money
supply. Then, discuss the circumstances under which the Fed is likely to decrease the
money supply. Discuss the short- and long-run effects of each.
ALTERNATIVE CLASSROOM EXAMPLE:
Suppose the Fed sells government bonds in the open market. The following would occur:
1. The supply of money will decrease, shifting the money supply curve to the left.
2. The equilibrium interest rate will rise, raising the cost of borrowing and the return on
saving.
Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand ❖ 373
H. The Role of Interest-Rate Targets in Fed Policy
1. In recent years, the Fed has conducted policy by setting a target for the federal funds rate
(the interest rate that banks charge one another for short-term loans).
2. Because changes in the money supply lead to changes in interest rates, monetary policy can
be described either in terms of the money supply or in terms of the interest rate.
I.
FYI: The Zero Lower Bound
1. What if the Fed’s target interest rate is already close to zero?
2. Some economists describe this situation as a liquidity trap.
a. Nominal interest rates cannot fall below zero.
b. Expansionary monetary policy cannot work.
3. Other economists are less concerned with this situation.
a. The central bank could alter inflationary expectations.
J.
Case Study: Why the Fed Watches the Stock Market (and Vice Versa)
1. A booming stock market expands the aggregate demand for goods and services.
a. When the stock market booms, households become wealthier, and this increased wealth
stimulates consumer spending.
2. Because one of the Fed’s goals is to stabilize aggregate demand, the Fed may respond to a
booming stock market by keeping the supply of money lower and raising interest rates. The
opposite would hold true if the stock market would fall.
Make sure that you point out to students that, while the media describes the actions
of the Federal Reserve as “changing interest rates,” they instead could be described
as “changing the money supply.”
Show students that the Fed can target either the money supply or the interest rate,
but not both.
374 ❖ Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand
3. Stock market participants also keep an eye on the Fed’s policy plans. When the Fed lowers
the money supply, it makes stocks less attractive because alternative assets (such as bonds)
pay higher interest rates. Also, higher interest rates may lower the expected profitability of
firms.
II. How Fiscal Policy Influences Aggregate Demand
A. Definition of fiscal policy: the setting of the level of government spending and taxation
by government policymakers.
B. Changes in Government Purchases
1. When the government changes the level of its purchases, it influences aggregate demand
directly. An increase in government purchases shifts the aggregate-demand curve to the
right, while a decrease in government purchases shifts the aggregate-demand curve to the
left.
C. The Multiplier Effect
1. Suppose that the government buys a product from a company.
a. The immediate impact of the purchase is to raise profits and employment at that firm.
b. As a result, owners and workers at this firm will see an increase in income, and will
therefore likely increase their own consumption.
c. Thus, total spending rises by more than the increase in government purchases.
Figure 4
Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand ❖ 375
2. Definition of multiplier effect: the additional shifts in aggregate demand that result
when expansionary fiscal policy increases income and thereby increases
consumer spending.
3. The multiplier effect continues even after the first round.
a. When consumers spend part of their additional income, it provides additional income for
other consumers.
4. A Formula for the Spending Multiplier
a. The
marginal propensity to consume
(
MPC
) is the fraction of extra income that a
household consumes rather than saves.
b. Example: The government spends $20 billion on new planes. Assume that
MPC
= 3/4.
c. Incomes will increase by $20 billion, so consumption will rise by
MPC
× $20 billion. The
second increase in consumption will be equal to
MPC
× (
MPC
× $20 billion) or
MPC
2 ×
$20 billion.
d. To find the total impact on the demand for goods and services, we add up all of these
e. This means that the multiplier can be written as:
Multiplier = (1 +
MPC
+
MPC
2 +
MPC
3 + . . .).
f. Because this expression is an infinite geometric series, it also can be written as:
g. Note that the size of the multiplier depends on the marginal propensity to consume.
5. Other Applications of the Multiplier Effect
a. The multiplier effect applies to any event that alters spending on any component of GDP
(consumption, investment, government purchases, or net exports).
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b. Examples include a reduction in net exports due to a recession in another country or a
stock market boom that raises consumption.
D. The Crowding-Out Effect
1. The crowding-out effect works in the opposite direction.
2. Definition of crowding-out effect: the offset in aggregate demand that results when
expansionary fiscal policy raises the interest rate and thereby reduces investment
spending.
5. The higher interest rate raises the cost of borrowing and the return to saving. This
discourages households from spending their incomes for new consumption or investing in
new housing. Firms will also decrease investment, choosing not to build new factories or
purchase new equipment.
6. Thus, even though the increase in government purchases shifts the aggregate-demand curve
Figure 5
Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand ❖ 377
a. If the multiplier effect is greater than the crowding-out effect, aggregate demand will rise
by more than $
X
.
E. Changes in Taxes
1. Changes in taxes affect a household’s take-home pay.
a. If the government reduces taxes, households will likely spend some of this extra income,
shifting the aggregate-demand curve to the right.
b. If the government raises taxes, household spending will fall, shifting the aggregate–
demand curve to the left.
2. The size of the shift in the aggregate-demand curve will also depend on the sizes of the
multiplier and crowding-out effects.
a. When the government lowers taxes and consumption increases, earnings and profits rise,
which further stimulate consumer spending. This is the multiplier effect.
F.
FYI: How Fiscal Policy Might Affect Aggregate Supply
1. Because people respond to incentives, a decrease in tax rates may cause individuals to work
more, because they get to keep more of what they earn. If this occurs, the aggregate-supply
curve would increase (shift to the right).
2. Changes in government purchases may also affect supply. If the government increases
spending on capital projects or education, the productive ability of the economy is enhanced,
shifting aggregate supply to the right.
III. Using Policy to Stabilize the Economy
A. The Case for Active Stabilization Policy
1. Example: The government raises taxes, lowering aggregate demand (shifting the curve to
the left).
a. The Fed can offset this government action by increasing the money supply.
b. This would lower interest rates and boost spending, shifting the aggregate-demand curve
back to the right.
378 ❖ Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand
a. One implication of the Employment Act is that the government should avoid being the
cause of economic fluctuations.
3. The Employment Act occurred in response to a book by John Maynard Keynes, an economist
who emphasized the important role of aggregate demand in explaining short-run fluctuations
in the economy.
4. Keynes also felt strongly that the government should stimulate aggregate demand whenever
necessary to keep the economy at full employment.
a. Keynes argued that aggregate demand responds strongly to pessimism and optimism.
5.
Case Study: Keynesians in the White House
a. In 1961, President Kennedy pushed for a tax cut to stimulate aggregate demand. Several
of his economic advisers were followers of Keynes.
b. In 2009, President Obama pushed for a stimulus bill that included several increases in
government spending.
6.
In the News: How Large is the Fiscal Policy Multiplier?
a. During the large economic recession of 2008–2009, many governments tried using
expansionary fiscal policy to stimulate aggregate demand.
b. This article from
The Economist
describes the debate over the estimated effects of these
policies.
B. The Case against Active Stabilization Policy
1. Some economists believe that fiscal and monetary policy tools should only be used to help
the economy achieve long-run goals, such as low inflation and rapid economic growth.
2. The primary argument against active policy is that these policy tools may affect the economy
with a long lag.
a. With monetary policy, the change in money supply leads to a change in interest rates.
This change in interest rates affects investment spending. However, investment decisions
are usually made well in advance, so the effects from changes in investment will not
likely be felt in the economy very quickly.
Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand ❖ 379
C. Automatic Stabilizers
1. Definition of automatic stabilizers: changes in fiscal policy that stimulate aggregate
demand when the economy goes into a recession without policymakers having to
take any deliberate action.
2. The most important automatic stabilizer is the tax system.
a. When the economy falls into a recession, incomes and profits fall.
3. Government spending is also an automatic stabilizer.
a. More individuals become eligible for transfer payments during a recession.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. According to the theory of liquidity preference, the interest rate adjusts to balance the supply
380 ❖ Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand
Questions for Review
1. The theory of liquidity preference is Keynes’s theory of how the interest rate is determined.
Quick Check Multiple Choice
1. b
Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand ❖ 381
Problems and Applications
1. a. When the Fed’s bond traders buy bonds in open-market operations, the money-supply
b. When an increase in credit card availability reduces the cash people hold, the money–
d. When households decide to hold more money to use for holiday shopping, the money–
382 ❖ Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand
e. When a wave of optimism boosts business investment and expands aggregate demand,
2. a. The increase in the money supply will cause the equilibrium interest rate to decline, as
b. As shown in Figure 5, the increase in aggregate demand will cause an increase in both
Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand ❖ 383
c. When the economy makes the transition from its short-run equilibrium to its long-run
3. a. When fewer ATMs are available, money demand is increased and the money-demand
curve shifts to the right from
MD
1 to
MD
2, as shown in Figure 6. If the Fed does not
384 ❖ Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand
5. a. The current situation is shown in Figure 7.
b. The Fed will want to stimulate aggregate demand. Thus, it will need to lower the interest
c. As shown in Figure 8, the Fed’s purchase of government bonds shifts the supply of
Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand ❖ 385
6. a. Legislation allowing banks to pay interest on checking deposits increases the return to
386 ❖ Chapter 21/The Influence of Monetary and Fiscal Policy on Aggregate Demand
8. a. The initial effect of the tax reduction of $20 billion is to increase aggregate demand by
9. If the marginal propensity to consume is 4/5, the spending multiplier will be 1/(1 – 4/5) = 5.
11. a. Expansionary fiscal policy is more likely to lead to a short-run increase in investment if