Summary of Lecture Notes from Chapter 16 and Practice Questions
KEY POINTS:
1. 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.
2. 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
interest rate reduces investment and, thereby, the quantity of goods and services demanded. In a
small open economy, an increase in the price level also increases the real exchange rate. An
increase in the real exchange rate makes Canadian-produced goods and services more expensive
relative to foreign-produced goods and services. As a result, Canada’s net exports fall, reducing the
quantity demanded of Canadian goods and services. The downward-sloping aggregate demand
curve expresses these negative relationships between the price level and the quantity demanded.
3. Policymakers can influence aggregate demand with monetary policy. An increase in the money
supply reduces the equilibrium interest rate for any given price level. Because a lower interest rate
stimulates investment spending, the aggregate-demand curve shifts to the right. In a small open
economy, the lower interest rate also means a fall in the exchange rate. Because a lower exchange
rate increases the quantity demanded of Canadian-produced goods and services, a monetary
injection in a small open economy shifts the aggregate-demand curve farther to the right than it does
in a closed economy. Conversely, a decrease in the money supply raises the equilibrium interest rate
for any given price level and shifts the aggregate-demand curve to the left. In a small open
economy, the higher interest rate also means a rise in the exchange rate and, consequently, a fall in
net exports. In a small open economy, then a monetary contraction shifts the aggregate-demand
curve farther to the left than it does in a closed economy.
4. 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.
5. 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 on investment tends to dampen the effects of fiscal
policy on aggregate demand. The multiplier effect is much smaller in an open economy than in a
closed economy.
6. In a small open economy with perfect capital mobility, fiscal policy may or may not cause a lasting
shift in the aggregate-demand curve. This depends on whether the Bank of Canada allows the
exchange rate to vary freely. If the Bank of Canada allows the exchange rate to be flexible, fiscal
policy has no lasting effect on the position of the aggregate-demand curve. This is so because the
change in the exchange rate exerts an effect on net exports that is opposite to the fiscal policy in its
influence on aggregate demand.
1 2 ☞ Chapter 16/The Influence of Monetary and Fiscal Policy on Aggregate Demand
7. 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, unexpected changes in economic conditions 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.
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 real exchange-rate effect.
B. All three effects occur simultaneously, but are not of equal importance.
1. Because a household’s money holdings are a small part of total wealth, the
wealth effect is relatively small.
2. Because imports and exports are a small fraction of Canadian GDP, the real
exchange-rate effect is also fairly small for Canada.
3. Thus, the most important reason for the downward-sloping aggregate demand
curve is the interest-rate effect.
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 Bank of Canada.
b. The Bank of Canada can alter the money supply using two methods.
First, using open market operations, which involves the buying and
selling of selling of federal government bonds. Second, by changing the
bank rate.
c. The bank rate is the interest rate on the loans the Bank of Canada
makes to commercial banks.
d. Because the Bank of Canada can control the size of the money supply
directly, the quantity of money supplied does not depend on any other
variables, including the interest rate. Thus, the supply of money is
represented by a vertical supply curve. Chapter 16/The Influence of Monetary and Fiscal Policy on Aggregate Demand ☞ 3
e. Increasing the bank rate reduces the money supply by reducing the
quantity of resources in the banking system and making loans more
expensive.
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.
b. The liquidity of money explains why people choose to hold it instead of
other assets that could earn them a higher return.
c. However, the return on other assets (the interest rate) is the opportunity
cost of holding money. All else equal, as the interest rate rises, the
quantity of money demanded will fall. Therefore, the demand for money
will be downward sloping.
d. Another key determinant of the quantity of money demanded is the level
of real GDP – the dollar value of all transactions causes – money demand
to change.
e. For a given interest rate, an increase in the dollar value of transactions
causes the demand for money to increase and the money demand curve
to shift rightward.
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 Bank of Canada has supplied. Thus, people will try to buy bonds or
deposit funds in an interest bearing bank account. This increases the
funds available for lending, pushing interest rates down. 4 ☞ Chapter 16/The Influence of Monetary and Fiscal Policy on Aggregate Demand
Figure 16.4
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 Bank of Canada has supplied. Thus, people will try to sell bonds
or withdraw funds from an interest bearing bank account. This
decreases the funds available for lending, pulling interest rates up.
E. 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. Chapter 16/The Influence of Monetary and Fiscal Policy on Aggregate Demand ☞ 5
3. At a higher interest rate, the cost of borrowing increases and the return on
saving increases. 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. This implies that as the price level increases, the quantity of goods and services
demanded falls. This is interest-rate effect.
5. As the price level rises, the real exchange rate rises, making Canadian-produced
goods more expensive relative to foreign-produced goods, causing net exports to
fall. This is the real exchange-rate effect.
F. Changes in the Money Supply
Figure 16.6 6 ☞ Chapter 16/The Influence of Monetary and Fiscal Policy on Aggregate Demand
1. Example: The Bank of Canada buys government bonds in open-market
operations.
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 increase in the demand for goods and services increases the demand for
money, causing the money demand curve to shift to the right, causing the
interest rate to rise slightly.
5. The quantity of goods and services demanded will rise at every price level,
shifting the aggregate-demand curve to the right, but the shift is smaller than it
otherwise would have been.
6. Thus, a monetary injection by the Bank of Canada increases the money supply,
leading to a lower interest rate, and a larger quantity of goods and services
demanded.
G. Open-Economy Considerations
1. Assuming that Canadian interest rates adjust to equal the world interest rate, an
increase in the money supply causes interest rates to fall, which lowers the cost
of borrowing and makes Canadian assets less attractive. The resulting fall in the
exchange rate, causes net exports to rise, causing aggregate demand to rise.
2. The increase in output causes the demand for money to rise causing interest
rates to increase until Canadian interest rates equal the world interest rate again.
3. Output rises by more than it would in a closed economy. Chapter 16/The Influence of Monetary and Fiscal Policy on Aggregate Demand ☞ 7
4. The Bank of Canada cannot simultaneously choose the size of the money supply
and the value of the Canadian dollar. By choosing to vary the money supply, the
Bank of Canada must allow the exchange rate to vary.
H. How Fiscal Policy Influences Aggregate Demand
A. Fiscal policy refers to the government’s choices regarding the overall level of government
purchases or taxes.
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.
2. There are two macroeconomic effects that cause the size of the shift in the
aggregate-demand curve to be different from the change in the level of
government purchases. They are called the multiplier effect and the crowding-
out effect.
C. The Multiplier Effect
1. When the government buys a product from a company, the immediate impact of
the purchase is to raise profits and employment at that firm. As a result, owners
and workers at this firm will see an increase in income, and will therefore likely
increase their own consumption. Thus, total spending rises by more than the
increase in government purchases.
Figure 16.8
2. Definition of multiplier effect: the additional shifts in aggregate demand
that result when ex
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