ECON 1100 Chapter 21: Chapter 21 Review Notes
The Monetary and Fiscal Policy on Aggregate Demand
● How government’s policy tools influence the position of the aggregate-demand curve, as
well as macroeconomic variables in the short run
○ Monetary policy (the supply of money set by the central bank)
○ Fiscal Policy (the levels of government spending and taxation set by the
president and congress)
○ Try to offer shifts in aggregate demands and stabilize the economy
● Other factors that shift aggregate demand
○ Desired spending by households and firms determine the overall demand for
goods and services
■ When desired spending changes, aggregate demand shifts, and if
policymakers do not respond, such shifts in aggregate demand cause
short-run fluctuations in output and employment
I. How Monetary Policy Influences Aggregate Demand
A. The Theory of Liquidity Preference: Keynes's theory that the interest rate
adjusts to bring money supply and money demanded into balance
1. Used to explain the factors that determine the economy’s interest rate
2. Explains both nominal and real interest rates
a) We hold constant the expected rate of inflation (short run)
(1) Nominal and real interest rates differ by a constant
(a) Nominal rate rises or falls, real rate does the same
3. Money Supply
a) Fed policy is fixed
b) Does not depend on the interest rate
4. Money demand
a) The liquidity of money explains its demand
(1) People choose to hold money because it can be used to
buy goods & services
b) Interest rate influences money demanded
(1) Interest rate is the opportunity cost of holding money as
opposed to an interest-bearing bond
(2) Higher interest rate ⇒ higher cost of holding money ⇒
reduces the quantity of money demanded
(3) Lower interest rates ⇒ lower cost of holding money ⇒
raises the quantity of money demanded
5. Equilibrium in the Money Market
a) An interest rate at which the quantity of money demanded exactly
balances the quantity of money supplied
b) If the interest rate is at any other level, people will adjust their
portfolios of assets, which will drive the interest rate toward
equilibrium
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(1) Interest rates above equil. ⇒ the quantity of money that
people want to hold is less than the quantity of money
supplied by the fed ⇒ those with surplus buy interest-
bearing bonds or depositing money in interest bearing
bank accounts ⇒ interest rates decrease ⇒ demand for
money increases until money supply & demand reaches
equil.
(a) Same applies conversely
B. The Downward Slope of the Aggregate-Demand Curve
1. Price level determines the quantity of goods demanded
a) Prices in the economy ↑ ⇒ people hold more money ⇒ quantity
demanded ↑ for any given interest rate ⇒ demand curve shifts
right demand curve shifts right
2. For a fixed money supply, the interest rate must rise to balance money
supply and demand
a) Interest rates MUST rise to balance the demand (discourage
additional demand), because MS has not changed
(1) Higher interest rates ↑ the cost of borrowing ⇒ demand for
investment falls
3. ↑ Price Levels ⇒ ↑ money demand ⇒ ↑ interest rate ⇒ decrease in
aggregate demand
4. Three steps for analysis of interest rate effects
a) A higher price level raises money demand
b) Higher money demand leads to a higher interest rate
c) A higher interest rate reduces the quantity of goods and services
demanded
5. Conversely,
a) A lower price level reduced money demand
b) Lower money demand leads to a lower interest rate
c) A lower interest rate increases the quantity of goods & services
demanded
C. Changes in Money Supply
1. When the fed increases the money supply, it lowers the interest rate ⇒ ↑
the quantity of goods & services demanded at any given price level,
shifting the aggregate-demand curve to the right
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