ECON 1000 Chapter Notes - Chapter 15: Open Market Operation, Aggregate Demand, Liquidity Preference
2 May 2018
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ECON 1000
Chapter 15: The Influence of Monetary and Fiscal Policy on Aggregate Demand:
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
• The aggregate-demand curve slopes downward for three reasons:
1. The wealth effect: A loe pie leel aises the eal alue of households’ oe
holdings, and higher real wealth stimulates consumer spending
2. The interest-rate effect: A lower price level lowers the interest rate as people try to
lend out their excess money holdings, and the lower interest rate stimulates
investment spending
3. The real exchange-rate effect: A lower price level reduces the real exchange rate.
This depreciation makes Canadian-produced goods and services cheaper relative to
foreign-produced goods and services, as a result, Canadian net exports rise
• They occur simultaneously to increase the quantity of goods and services demanded
when the price level falls and to decrease it when the price level rises
The theory of Liquidity Preference:
• Theo of liuidit pefeee: Kee’s theo that the iteest ate adjusts to ig
money supply and money demand into balance
• This theory of interest rate determination will help explain the downward slope of the
aggregate-demand curve, as well as how monetary and fiscal policy can shift this curve
Money Supply:
• The money supply in the Canadian economy is controlled by the Bank of Canada
• The Bank of Canada alters the money supply using two methods:
1. Changing the bank rate: the bank rate is the interest rate on the loans that the
Bank of Canada makes to commercial banks
2. Changing the quantity of reserves in the banking system through an open-
market operation
• We can assume that the quantity of money supplied in the economy Is fixed at whatever
level the Bank of Canada decides to set it
The Supply of Money:
• Quatit of oe supplies does’t depend on the interest rate; supply curve is vertical
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Money Demand:
• Interest rate is the opportunity cost of holding money, when you hold wealth as cash in
your wallet, you lose the interest you could have earned on an interest-bearing bond
• An increase in the interest rate raises the cost of holding money and, as a result, reduces
the quantity of money demanded
• A decrease in the interest rate reduces the cost of holding money and raises the
quantity demanded
The Demand for Money:
• Because the interest rate measures the opportunity cost of holding noninterest-bearing
money instead of interest-bearing bonds, an increase in the interest rate reduces the
quantity of money demanded
• A downward-sloping demand curve represents this negative relationship
Shifts in the Demand for Money:
• If the dollar value of transactions increases because of an increase in either prices or
real GDP, then for any interest rate, people will hold more of their assets as money, the
money-demand curve shifts to the right
• If the dollar value of transactions decreases because of a decrease in either price or real
GDP, then for any interest rate people will hold less of their assets as money, the
money-demand curve shifts to the left
Equilibrium in the Money Market:
• According to the theory of liquidity preference, the interest rate adjusts to balance the
supply and demand for money
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• There is one interest rate, called the equilibrium interest rate, at which the quantity of
money demanded exactly balances the quantity of money supplied
• If the interest rate is at any other level, people will try to adjust their portfolios of assets
and, as a result, drive the interest rate toward the equilibrium
• If the interest rate is above the equilibrium level, the quantity of money people want to
hold is less than the quantity the Bank of Canada has created, and this surplus of money
puts downward pressure on the 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 Bank of Canada has created, and this shortage of
money puts upward pressure on the interest rate
• 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
the Bank of Canada has created
The Downward Slope of the Aggregate-Demand Curve:
The Money Market and the Slope of the Aggregate Demand Curve:
• An increase in the price level from P1 to P2 shifts the money-demand curve to the right,
this increase in money demand causes the interest rate to rise
• Because the interest rate is the cost of borrowing, the increase in the interest rate
reduces the quantity of goods and services demanded
• This negative relationship between the price level and quantity demanded is
represented with a downward-sloping aggregate-demand curve
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Chapter 15: the influence of monetary and fiscal policy on aggregate demand: The supply of money: qua(cid:374)tit(cid:455) of (cid:373)o(cid:374)e(cid:455) supplies does(cid:374)"t depend on the interest rate; supply curve is vertical. If the dollar value of transactions increases because of an increase in either prices or real gdp, then for any interest rate, people will hold more of their assets as money, the money-demand curve shifts to the right. If the dollar value of transactions decreases because of a decrease in either price or real. Gdp, then for any interest rate people will hold less of their assets as money, the money-demand curve shifts to the left. If the interest rate is at any other level, people will try to adjust their portfolios of assets and, as a result, drive the interest rate toward the equilibrium. Changes in the money supply: whenever the quantity of goods and services demanded changes for a given price level, the aggregate demand curve shifts.
