How Monetary Policy Influences Aggregate Demand
The most important reason for downward slopingAD is the interest-rate effect!
Theory of liquidity preference: Keynes’s theory that the interest rate adjusts to
bring money supply and money demand into balance
Fed alters through open-market operations (buying and selling bonds) and
changing the discount rate
Fixed money supply
Money has highest liquidity because it is our medium of exchange. People
hold it because it can be used to buy goods and services.
Increase in the interest rate, raises cost of holding money because you could
be making money on it in the bank, so the demand decreases.
Downward Slope ofAD curve
Increase in price level, causes an increase in money demand (need more money to
pay for more expensive things)
This causes an increase in the interest rates because supply is fixed and
demand curve shifts right. (money market graph)
• Also quantity of goods demanded decreases (AD curve)
Changes in Money Supply
Whenever the quantity of goods and services demanded changes for any given
price level, theAD curve shifts.
When the fed increases money supply, it lowers the interest rate and increases the
quantity of goods and services demanded (lower cost t borrowing), shiftingAD
curve to the right.
Role of Interest-rate Targets in Fed Policy
Set target for federal funds rate (interest rate banks charge other banks) instead of
money supply because it’s