34 The Influence of

Monetary and Fiscal Policy on Aggregate

Demand

Aggregate Demand

• Many factors influence aggregate demand besides monetary and fiscal policy.

• In particular, desired spending by households and business firms determines the overall demand for goods and services.

Aggregate Demand

• When desired spending changes, aggregate demand shifts, causing short-run fluctuations in output and employment.

• Monetary and fiscal policy are sometimes used to offset those shifts and stabilize the economy.

34.1 HOW MONETARY

POLICY INFLUENCES AGGREGATE DEMAND

34.1 HOW MONETARY POLICY INFLUENCES AGGREGATE DEMAND

• The aggregate demand curve slopes downward for three reasons:

– The wealth effect

– The interest-rate effect

– The exchange-rate effect

34.1 HOW MONETARY POLICY INFLUENCES AGGREGATE DEMAND

• For the Chinese economy, the most important reason for the downward slope of the aggregate-demand curve is the wealth effect.

• For the U.S. economy, the most important reason for the downward slope of the aggregate-demand curve is the interest-rate effect.

34.1.1 The Theory of Liquidity Preference

• Keynes developed the theory of liquidity preference in order to explain what factors determine the economy’s interest rate.

• According to the theory, the interest rate adjusts to balance the supply and demand for money.

34.1.1 The Theory of Liquidity Preference

• Money Supply– The money supply is controlled by the Fed

through:• Open-market operations• Changing the reserve requirements• Changing the discount rate

– Because it is fixed by the Fed, the quantity of money supplied does not depend on the interest rate.

– The fixed money supply is represented by a vertical supply curve.

34.1.1 The Theory of Liquidity Preference• Money Demand

– Money demand is determined by several factors.• According to the theory of liquidity preference, one of

the most important factors is the interest rate.• 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 is reduced.

34.1.1 The Theory of Liquidity Preference

• Equilibrium in the Money Market

– According to the theory of liquidity preference:

• The interest rate adjusts to balance the supply and demand for money.

• There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded equals the quantity of money supplied.

34.1.1 The Theory of Liquidity Preference

• Equilibrium in the Money Market

– Assume the following about the economy:

• The price level is stuck at some level.

• For any given price level, the interest rate adjusts to balance the supply and demand for money.

• The level of output responds to the aggregate demand for goods and services.

Figure 1 Equilibrium in the Money Market

Quantity ofMoney

InterestRate

0

Moneydemand

Quantity fixedby the Fed

Moneysupply

r2

M2dMd

r1

Equilibriuminterest

rate

34.1.2 The Downward Slope of the Aggregate Demand Curve

• The price level is one determinant of the quantity of money demanded.

• A higher price level increases the quantity of money demanded for any given interest rate.

• Higher money demand leads to a higher interest rate.

• The quantity of goods and services demanded falls.

34.1.2 The Downward Slope of the Aggregate Demand Curve

• The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded.

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

Quantityof Money

Quantity fixedby the Fed

0

InterestRate

Money demand at price level P2 , MD2

Money demand atprice level P , MD

Moneysupply

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

3. . . . whichincreasesthe equilibriuminterestrate . . .

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34.1.3 Changes in the Money Supply

• The Fed can shift the aggregate demand curve when it changes monetary policy.

• An increase in the money supply shifts the money supply curve to the right.

• Without a change in the money demand curve, the interest rate falls.

• Falling interest rates increase the quantity of goods and services demanded.

Figure 3 A Monetary Injection

MS2Moneysupply, MS

Aggregatedemand, AD

YY

P

Money demand at price level P

AD2

Quantityof Money

0

InterestRate

r

r2

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

Quantityof Output

0

PriceLevel

3. . . . which increases the quantity of goods and services demanded at a given price level.

2. . . . theequilibriuminterest ratefalls . . .

1. When the Fedincreases themoney supply . . .

34.1.3 Changes in the Money Supply

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

• When the Fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the left.

34.1.4 The Role of Interest-Rate Targets in Fed Policy

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

• Changes in monetary policy can be viewed either in terms of a changing target for the interest rate or in terms of a change in the money supply.

• A target for the federal funds rate affects the money market equilibrium, which influences aggregate demand.

34.2 HOW FISCAL POLICY

INFLUENCES AGGREGATE DEMAND

34.2 HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND

• Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes.

• Fiscal policy influences saving, investment, and growth in the long run.

• In the short run, fiscal policy primarily affects the aggregate demand.

34.2.1 Changes in Government Purchases

• When policymakers change the money supply or taxes, the effect on aggregate demand is indirect—through the spending decisions of firms or households.

• When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly.

34.2.1 Changes in Government Purchases

• There are two macroeconomic effects from the change in government purchases:

– The multiplier effect

– The crowding-out effect

34.2.2 The Multiplier Effect

• Government purchases are said to have a multiplier effect on aggregate demand.

– Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.

34.2.2 The Multiplier Effect

• The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Figure 4 The Multiplier Effect

Quantity ofOutput

PriceLevel

0

Aggregate demand, AD1

$20 billion

AD2

AD3

1. An increase in government purchasesof $20 billion initially increases aggregatedemand by $20 billion . . .

2. . . . but the multipliereffect can amplify theshift in aggregatedemand.

34.2.3 A Formula for the Spending Multiplier

• The formula for the multiplier is:

Multiplier = 1/(1 - MPC)= 1/ MPS

• An important number in this formula is the marginal propensity to consume (MPC).

– It is the fraction of extra income that a household consumes rather than saves.

34.2.3 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.

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34.2.5 The Crowding-Out Effect

• Fiscal policy may not affect the economy as strongly as predicted by the multiplier.

• An increase in government purchases causes the interest rate to rise.

• A higher interest rate reduces investment spending.

34.2.5 The Crowding-Out Effect

• This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.

• The crowding-out effect tends to dampen (vt. make sth. less strong, restrain) the effects of fiscal policy on aggregate demand.

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Quantityof Money

Quantity fixedby the Fed

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34.2.5 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.

34.2.6 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 it on consumer goods.

– Increased household spending shifts the aggregate-demand curve to the right.

34.2.6 Changes in Taxes

• The size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding-out effects.

• It is also determined by the households’ perceptions (n. way of seeing, or understanding sth.看法 ,

理解 ) about the permanency of the tax change.

34.3 USING POLICY TO

STABILIZE THE ECONOMY

34.3 USING POLICY TO STABILIZE THE ECONOMY

• Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946.

34.3.1 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.

34.3.2 The Case against Active Stabilization Policy

• Some economists argue that monetary and fiscal policy destabilizes the economy.

• Monetary and fiscal policy affect the economy with a substantial lag.

• They suggest the economy should be left to deal with the short-run fluctuations on its own.

34.3.3 Automatic Stabilizers

• Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

• Automatic stabilizers include the tax system and some forms of government spending.

34.3.3 Automatic Stabilizers• The most important automatic stabilizer is the tax

system. When the economy goes into a recession, the amount of taxes collected by the government falls automatically because almost all taxes are closely tied to economic activity. The personal income tax depends on households’incomes, the payroll tax depends on workers’earnings, and the corporate income tax depends on firms’profits. Because incomes, earnings, and profits all fall in a recession, the governments’s tax revenue falls as well. This automatic tax cut stimulates aggregate demand and, thereby, reduces the magnitude of economic fluctuations.

34.3.3 Automatic Stabilizers• Government spending also acts as an automatic

stabilizer. In particular, when the economy goes into a recession and workers are laid off, more people apply for unemployment insurance benefits, welfare benefits, and other forms of income support. This automatic increase in government spending stimulates aggregate demand at exactly the time when aggregate demand is insufficient to maintain full employment. (Indeed, when the unemployment insurance system was first enacted in the 1930s, economists who advocated this policy did so in part because of its power as an automatic stabilizer.)

34.3.3 Automatic Stabilizers

• The automatic stabilizer in the U.S. economy are not sufficiently strong to prevent recessions completely. Nonetheless, without these automatic stabilizers, output and employment would probably be more volatile than they are.

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.

Mankiw,ch34, Question for Review• 1.What is the theory of liquidity preference? How does it

help explain the downward slope of the aggregate-demand curve?

• 2. Use the theory of liquidity preference to explain how a decrease in the money supply affects the aggregate-demand curve.

• 3. (Mankiw-Chapter34 ) 解释在封闭经济中，为什么政府税收乘数小于政府支出乘数？

• 4. (Mankiw-Chapter34)解释为什么封闭经济中的支出乘数大于开放经济的支出乘数？

复习题1. 什么是流动偏好理论？ 这种理论如何有助于解释总需求曲线的向右下方倾斜？

2. 用流动偏好理论解释货币供给减少如何影响总需求曲线。

3. 政府支出 30 亿美元购买警车。解释为什么总需求的增加会大于或小于 30 亿美元。

4. 假设对消费者信心衡量指标的调查表明，悲观主义情绪蔓延全国。如果决策者无所作为，总需求会发生什么变动？ 如果美联储想稳定总需求，它应该怎么做？ 如果美联储无所作为，国会为了稳定总需求应该做什么 ？

5. 举出一个起到自动稳定器作用的政府政策的例子。解释为什么这种政策有这种效应。

(Mankiw-Chapter 34-p778) 1.Explain how each of the following developments would affect the supply of money, the demand for money, and the interest rate. Illustrate your answers with diagrams.

a. A wave of optimism boosts business investment.b. The Central Bank reduces reserve requirements. c. An increase in oil prices shifts the short-run

aggregate-supply curve upward. d. Households decide to hold more money to use for

holiday shopping.

MS

Md

Md'

r1

r2

利率

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MS

Md

r1

r2

利率

货币量(b)The Central Bank reduces reserve requirements signifies that the supply of money will shift rightward with constant the demand for money, the interest rate will decline.

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MS

Md

Md'

r1

r2

利率

货币量(c) An increase in oil prices shifts the short-run An increase in oil prices shifts the short-run aggregate-supply curve upward. High price increase the aggregate-supply curve upward. High price increase the demand for money and increase interest rate.demand for money and increase interest rate.

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(Mankiw Chapter 34 -p778.) 2. Suppose banks install automatic teller machines on every block and, by making cash readily available, reduce the amount of money people want on hold.a. Assume the Fed does not change the money supply. According to the theory of liquidity preference, what happens to the interest rate? What happens to aggregate demand?b. If the Fed wants to stabilize aggregate demand, how should it respond?

(Mankiw Chapter 34 -p778.) 3.Consider two policies----a tax cut that will last for only one year, and a tax cut that is expected to be permanent. Which policy will stimulate greater spending by consumers? Which policy will have the greater impact on aggregate demand? Explain.

(Mankiw Chapter 34 -p778.) 4. The interest rate in the United States fell sharply during 1991. Many observers believed this decline showed that monetary policy was quite expantionary during the year. Could this conclusion be incorrect? (Hint:The United States hit the trough of a recession in 1991.)

(Mankiw Chapter 34 -p778.) 5. In the early 1980s, new legislation allowed banks to pay interest on checking deposits, which they could not do previously.a. If we define money to include checking deposits, what effect did this legislation have on money demand? Explain.b. If the Federal Reserve had maintained a constant money supply in the face of this change, what would have happened to the interest rate? What would have happen to aggregate demand and aggregate output?C. If the Federal Reserve had maintained a constant market interest rate (the interest rate on nonmonetary assets) in the face of this change, what change in the money supply would have been necessary? What would have happened to aggregate demand and aggregate output?

(Mankiw, Chapter34.--p779.) 6.This chapter explains that expansionary monetary policy reduces the interest rate and thus stimulates demand for consumption and investment goods. Explain how such policy also stimulates the demand for net exports.

(Mankiw, Chapter34.--p779.) 7. Suppose economists observe that an increase in government spending of $10 billion raises the total demand for goods and services by $30 billion.a. If these economists ignore the possibility of crowding out, what would they estimate the marginal propensity to consume (MPC) to be?b. Now suppose the economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than their initial one?

(Mankiw-p779, Chapter 34) 8. Suppose the government reduces taxes by $20 billion, that there is no crowding out, and that the marginal propensity to consume is 3/4.

a. What is the initial effect of the tax reduction on aggregate demand?

b. What additional effects follow this initial effect? What is the total effect of the tax cut on aggregate demand?

c. How does the total effect of this $20 billion tax cut compare to the total effect of a $20 billion increase in government purchase? Why?

9. Suppose consumers suddenly become more optimistic about their future incomes and decide to purchase $30 billion of additional goods and services. Will this change have a “multiplied” effect on total output? Explain.

((Mankiw Chapter 34 -p779.) 9Mankiw Chapter 34 -p779.) 9. Suppose government spending increases.Would the effect on aggregate demand be larger if the Federal Reserve took no action in response, or if the Fed were committed to maintaining a fixed interest rate? Explain.

((Mankiw Chapter 34 -p779.) Mankiw Chapter 34 -p779.) 10. In which of the following circumstances is expansionary fiscal policy more likely to lead to a short-run increase in investment? Explain.a. when the investment accelerator is large or when it is small?b. when the interest sensitivity of investment is large, or when it is small.

((Mankiw Chapter 34 -p779.) Mankiw Chapter 34 -p779.) 11. Assume the economy is in a recession. Explain how each of the following policies would affect consumption and investment. In each case, indicate any direct effects, any effects resulting from changes in total output, any effects resulting from changes in the interest rate, and the overall effect. If there are conflicting effects making the answer ambiguous, say so.

a. an increase in government spending b. a reduction in taxes c. an expansion of the money supply

• ((Mankiw Chapter 34 -p779.) Mankiw Chapter 34 -p779.) 12. For various reasons, fiscal policy changes automatically when output and employment fluctuate.

a. Explain why tax revenue changes when the economy goes into a recession.

b. Explain why government spending changes when the economy goes into a recession.

c. If the government were to operate under a strict balanced-budget rule, what would it have to do in a recession? Would that make the recession more or less severe?

(Mankiw Chapter 34 -p731.) 14. In response to an increase in the money supply, would the following things be smaller, larger, or no different in the long run than in the short run?

a. Consumer expendituresb. The price levelc. The interest rated. Aggregate output