Chapter 34: The Influence of Monetary and Fiscal
Policy on Aggregate Demand
How Monetary Policy Influences Aggregate Demand
The AD curve shows the total quantity of goods and services demanded in the economy for
any given price level. The AD curve slopes for three reasons:
1. The wealth effect: A lower price level raises the real value of households’ money
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 exchange rate effect: When a lower price level lowers the interest rate, investors
move some of their funds overseas and cause the domestic currency to depreciate
relative to foreign currencies. This depreciation makes domestic goods cheaper
compared to foreign goods and stimulates spending on net exports.
These effects occur simultaneously to increase the number of goods and services
demanded when the price level falls and to decrease it when the price level rises, but they
are not equally important. The least important of the three is the wealth effect, the exchange
rate is the second most important and the interest rate effect is the most important. We
develop a theory of how the interest rate is determined, called the theory of liquidity
preference.
Theory of Liquidity Preference
The theory is just an application of supply and demand. Recall the difference between the
nominal interest rate (The interest rate as usually reported) and the real interest rate (the
interest rate corrected for the effects of inflation.) When the nominal interest rate rises or
falls, the real interest rate that people expect to earn rises or falls as well.
Money Supply
The first element of the theory of liquidity is the supply of money. The money supply is
controlled by the central bank. The central bank can alter the money supply through the
purchase and sales of government bonds in outright open-market operations. Our goal here
is to examine how changes in the money supply affect the AD for goods and services.
Because the money supply is fixed by the central bank policy, it does not depend on other
economic variables. We represent the fixed money supply with a vertical supply curve. What
is important to remember is that central banks interact with the banking system by setting
overnight rates. This sets the tone for the structure of interest rate throughout the economy.
It is these interest rates that are influenced by liquidity preference.
, Money Demand
The second element of the theory of liquidity is the demand for money. As a starting point for
understanding money demand, recalled that any assets liquidity refers to the ease with
which that asset is converted into money. Although many factors determine the quantity of
money demanded, the one emphasized by the theory of liquidity preference is the interest
rate. The reason is that the interest rate is the opportunity cost of holding money. That is,
when you hold cash instead of investing in an interest-bearing bond or bank account, you
forgo the benefits of the interest you could have earned. There is an incentive for people to
exchange cash holdings for interest-bearing deposits and this reduces the quantity of money
demanded. A decrease in interest rate reduces the opportunity cost of holding money,
therefore more people will hold onto their cash. Thus, in the figure above, the money
demand curve slopes downwards.
Equilibrium in the Money Market
There is one interest rate, called the equilibrium interest rate, as which the quantity of money
demanded exactly balances the quantity of money supplied. Suppose that the interest rate is
above the equilibrium level, such as r1. In this case, the quantity of money that people want
to hold M1 is less than the quantity of money that the central bank supplied. Those people
who are holding the surplus of money will try to get rid of it by buying interest-bearing bonds
or bank accounts. Banks and bond suppliers want to pay lower interest rates, they respond
to this surplus of money by lowering the interest rates they offer. As the interest rate falls,
people become more willing to hold the money until, at the equilibrium interest rate, people
are happy to hold exactly the amount of money the central bank has supplied. At interest
Policy on Aggregate Demand
How Monetary Policy Influences Aggregate Demand
The AD curve shows the total quantity of goods and services demanded in the economy for
any given price level. The AD curve slopes for three reasons:
1. The wealth effect: A lower price level raises the real value of households’ money
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 exchange rate effect: When a lower price level lowers the interest rate, investors
move some of their funds overseas and cause the domestic currency to depreciate
relative to foreign currencies. This depreciation makes domestic goods cheaper
compared to foreign goods and stimulates spending on net exports.
These effects occur simultaneously to increase the number of goods and services
demanded when the price level falls and to decrease it when the price level rises, but they
are not equally important. The least important of the three is the wealth effect, the exchange
rate is the second most important and the interest rate effect is the most important. We
develop a theory of how the interest rate is determined, called the theory of liquidity
preference.
Theory of Liquidity Preference
The theory is just an application of supply and demand. Recall the difference between the
nominal interest rate (The interest rate as usually reported) and the real interest rate (the
interest rate corrected for the effects of inflation.) When the nominal interest rate rises or
falls, the real interest rate that people expect to earn rises or falls as well.
Money Supply
The first element of the theory of liquidity is the supply of money. The money supply is
controlled by the central bank. The central bank can alter the money supply through the
purchase and sales of government bonds in outright open-market operations. Our goal here
is to examine how changes in the money supply affect the AD for goods and services.
Because the money supply is fixed by the central bank policy, it does not depend on other
economic variables. We represent the fixed money supply with a vertical supply curve. What
is important to remember is that central banks interact with the banking system by setting
overnight rates. This sets the tone for the structure of interest rate throughout the economy.
It is these interest rates that are influenced by liquidity preference.
, Money Demand
The second element of the theory of liquidity is the demand for money. As a starting point for
understanding money demand, recalled that any assets liquidity refers to the ease with
which that asset is converted into money. Although many factors determine the quantity of
money demanded, the one emphasized by the theory of liquidity preference is the interest
rate. The reason is that the interest rate is the opportunity cost of holding money. That is,
when you hold cash instead of investing in an interest-bearing bond or bank account, you
forgo the benefits of the interest you could have earned. There is an incentive for people to
exchange cash holdings for interest-bearing deposits and this reduces the quantity of money
demanded. A decrease in interest rate reduces the opportunity cost of holding money,
therefore more people will hold onto their cash. Thus, in the figure above, the money
demand curve slopes downwards.
Equilibrium in the Money Market
There is one interest rate, called the equilibrium interest rate, as which the quantity of money
demanded exactly balances the quantity of money supplied. Suppose that the interest rate is
above the equilibrium level, such as r1. In this case, the quantity of money that people want
to hold M1 is less than the quantity of money that the central bank supplied. Those people
who are holding the surplus of money will try to get rid of it by buying interest-bearing bonds
or bank accounts. Banks and bond suppliers want to pay lower interest rates, they respond
to this surplus of money by lowering the interest rates they offer. As the interest rate falls,
people become more willing to hold the money until, at the equilibrium interest rate, people
are happy to hold exactly the amount of money the central bank has supplied. At interest
