Chapter all: The Influence of Monetary and Fiscal Policy on Aggregate Demand

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1 Dec 2016
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The Influence of Monetary and Fiscal Policy on Aggregate
How Monetary Policy Influences Aggregate Demand
The wealth effect: the change in spending that accompanies a change in
perceived wealth.
The interest-rate effect: the impact of a rise in the cost of borrowing on
production costs due to price inflation within an economy.
The exchange-rate effect: When a lower price level reduces the interest
rate, investors move some of their funds overseas in search of higher
returns.
Theory of liquidity preference: a theory that the interest rate adjusts to
bring money supply and money demand into balance.
o Money supply: the quantity of money supplied is the same,
regardless of the prevailing interest rate. This figure represents a
fixed money supply with a vertical supply curve.
o Money Demand: interest rate is the opportunity cost of holding
money.
o Equilibrium in the Money Market
- Equilibrium interest rate: the quantity of money demanded
exactly balances the quantity of money supplied.
The downward slope of the aggregate-demand curve
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o (a) shows that an increase in the price level shifts the money-
demand curve to the right from MD1 to MD2.
o (b) shows that a negative relationship between the price level and
quantity demand is represented with a downward-sloping aggregate-
demand curve.
Changes in the money supply
o (a) shows that an increase in the money supply reduces the
equilibrium interest rate. 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.
o (b) shows that the aggregate-demand curve shirts to the right.
The role of interest-rate targets in Fed policy
o Monetary policy can be described either in in terms of the money
supply or in terms of the interest rate.
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How Fiscal Policy Influences Aggregate Demand
Multiplier effect: an effect in economics in which an increase in
spending produces an increase in national income and consumption
greater than the initial amount spent.
o Multiplier= 1/(1-MPC)
o This figure shows that this multiplier effect arises because increases
in aggregate income stimulate additional spending by consumers.
Crowding-out effect: when expansionary fiscal policy raises the interest
rate and thereby reduces investment spending.
o (a) shows that when the higher level of income shifts the money-
demand curve to the right, the interest rate must rise from r1 to r2 to
keep supply and demand in balance.r2.
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