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Lecture

Chapter 15 Influence of Monetary and Fiscal Policy on Aggregate Demand

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Department
Economics
Course
ECN 204
Professor
Paul Missios
Semester
Winter

Description
Chapter 15: Influence of Monetary and Fiscal Policy on Aggregate Demand -Monetary and fiscal policy can each influence aggregate demand- a change in one of these policies can lead to a short-run fluctuation in output and prices. Money Market: Money Supply and Money Demand; Vertical Axis- Interest Rate Horizontal Axis- Quantity of money Aggregate Demand Curve: Vertical axis- Price Level Horizontal Axis- Quantity of Output How Monetary Policy Influences Aggregate Demand -The aggregate demand curve shows the total quantity of goods and services demanded in the economy for any price level. AD slopes downward because of the wealth effect, the interest rate effect, and the exchange-rate effect. We will focus on the interest-rate effect because it the most important in a CLOSED economy. We will see how policy can help short run economic fluctuations. The Theory of Liquidity Preference Theory of Liquidity Preference: Keyness theory that the interest rate adjusts to bring more money supply and money demand into balance -A simple theory of the interest rate (denoted r), r adjusts to balance supply and demand for money 1: Money Supply. Horizontal Axis: quantity of money, Vertical Axis: interest rate. We assume the BOC controls the money supply directly and assumed the supply of money is not affected at all by changes in interest rate. For this reason, the money-supply curve is a vertical line. -The Bank of Canada alters the money of supply using two methods: the first is to change the quantity of reserves in the banking system through what is known as an open-market operation such as BOC buying and selling government bonds in bond market OR buying and selling foreign currencies in the market for foreign currency exchange. The second way BOC can alter the money supply is by changing the bank rate. The bank rate is the interest rate on the loans that the BOC makes to commercial banks. 2: Money Demand -Money demand reflects how much wealth people want to hold in liquid form. One factor that is important in determining the quantity of money demanded is the interest rate because it is the opportunity cost of holding money. An increase in the interest rate raises the cost of holding money = reducing the quantity of money demanded. A decrease in interest rate reduces the cost of holding money and raises the quantity demanded. Therefore, the money demand curve slopes DOWNWARDS. -Variables that influence money demand: Y, r, and P. Suppose real income (Y) rises. If Y rises, households want to buy more goods and services, so they need more money. To get this money, they attempt to sell some of their bonds = an increase in Y causes an increase in money demand -People hold money in order to buy g&s. IF the dollar value of transactions increases because of an increase in either prices or GDP, then for any given interest rate people will hold more of their assets as money = money demand shifts to the RIGHT. If the dollar value of transaction decreases because of a decrease in price or GDP, then for any given interest rate, people will hold less of their assets as money = money demand shifts to the LEFT. Exercise 1: The determinants of money demand A: Suppose r rises, but Y and P are unchanged. What happens to money demand? Answer: r is the opportunity cost of holding money. An increase in r reduces money demand: households attempt to buy bonds to take advantage of the higher interest rate. Hence, an increase in r causes a decrease in money demand, other things equal. B: Suppose P rises, but Y are r are unchanged. What happens to money demand? Answer: If Y is unchanged, people will want to buy the same amount of g&s. Since P is higher, they will need more money to do so. Hence, an increase in P causes an increase in money demand. Equilibrium in the Money Market -The interest rate adjusts to bring the quantity of money supplied and the quantity of money demanded in balance. If the interest rate is above the equilibrium level, the quantity of money people want to hold is less than the quantity the BOC has created = surplus of money puts downward pressure on interest rate. If the interest rate is BELOW the equilibrium level, the quantity of money people want to hold is greater than the quantity the BOC has created, and this shortage of money puts upward pressure on interest rate. Therefore, 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 that the BOC has created. Monetary Policy and Aggregate Demand: To achieve macroeconomic goals, the BOC can use monetary policy to shift and AD curve. The BOC can change the money supply buy buying and selling government bonds by conducting open market operations. This changes the interest rate and shifts the AD curve. The Downward Slope of Aggregate Demand Curve Decrease in Price Level: the fall in the interest rate reduces the cost of borrowing, so it stimulates investment firms borrow more money (or sell more bonds/issue more stock) to finance projects and households borrow more money to buy new houses. Increase in Price Level: an increase in price level shifts the money demand curve to the right. This increase in demand causes interest rate to rise from r1 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 Y1 to Y2. This negative relationship between the price level and quantity demanded is represented with a downward slopping aggregate demand curve. -Higher price level raises money demand, higher money demand leads to higher interest rate, a higher interest rate reduces the quantity of goods and services demanded. -Lower price level decreases money demand, lower money demand leads to lower interest rate, a lower interest rate increases the quantity of goods and services demanded.Changes in the Money Supply -Whenever the quantity of goods and services demanded changes for a given price level, the aggregate demand curve shifts. The Graph Depicts DECREASE in Money Supply Increase in Money Supply/Monetary Injection: BOC increases money supply by buying government bonds in open market operation. An increase in the money supply from MS1 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. At the same time, the increase in output requires that people hold more money. This causes the demand for money to increase from MD1 to MD2 and causes a partial reversal in the interest rate, from r2 to r3. As a result, the increase in the quantity demanded of g&s is smaller than it would otherwise have been. In the end, the aggregate demand curve shifts to the right from AD1 to AD2. Summary: When BOC increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting th
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