Chapter 15 - The Influence of Monetary and Fiscal Policy on Aggregate Demand

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24 Apr 2012
Wednesday March 28th, 2012
Chapter 15
The Influence of Monetary and Fiscal Policy on Aggregate Demand
Aggregate Demand:
-Recall, the AD curve slopes downward for three reasons:
The wealth effect
The interest-rate effect
The exchange-rate effect
-Supply-demand model that helps explain the interest-rate effect and how monetary policy affects
aggregate demand
-the wealth effect is less important because money holdings are only a small part of household wealth
-exchange rate effect is less important because imports and exports are a relatively small percentage of
Theory of Liquidity Preference:
-A simple theory of the interest rate (denoted r)
-r adjusts to balance supply and demand
for money
-Money supply: assume fixed by central bank, does not depend on interest rate
-Money demand reflects how much wealth people want to hold in liquid form.
-for example, suppose household wealth includes only two assets:
Money liquid but pays no interest
Bonds pay interest but not as liquid
-A household’s “money demand” reflects its preference for liquidity
-The variables that influence money demand:
Y, r, and P.
-in order to understand the interest-rate effect and how monetary policy shifts AD, you will need to
know how money demand depends on r and P
Money Demand:
-Suppose real income (Y) rises. Other things equal, what happens to money demand?
-If Y rises:
Households want to buy more g&s, so they need more money
-To get this money, they attempt to sell some of their bonds.
-For example: an increase in Y causes an increase in money demand, other things equal
How is “r” Determined?
-MS curve is vertical:
Changes in r do not affect MS, which is fixed by the Bank of Canada
-MD curve is downward sloping:
A fall in r increases money demand
Monetary Policy and Aggregate Demand:
-To achieve macroeconomic goals, the BoC can use monetary policy to shift the AD curve
-The BoC can change the money supply by buying and selling government bonds by conducting open
market operations
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