The fixed money supply is represented by a vertical supply curve.

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1 Chapter 20 The Influence of Monetary and Fiscal Policy on Aggregate Demand OUTLINE: 1. The theory of liquidity preference. 2. How monetary policy affects aggregate demand. 3. How fiscal policy affects aggregate demand. 4. The economy in the short-run and long-run. Theory of Liquidity Preference: The Supply and Demand for Money (by Keynes) The Liquidity Preference Theory of interest rates states that...market rates of interest adjust to balance the supply and demand for money. 1. An increase in the price level causes an increase in the demand for money, 2. which leads to higher interest rates, 3. which leads to reduced total spending (i.e. AD). The Supply and Demand for Money The Money Supply is controlled by the B of C, which alters the money supply in three ways: 1. Open-Market Operations 2. Changing the Bank Rate 3. Buying and selling Canadian dollars in the market for foreign-currency exchange The quantity of money supplied in the economy is fixed at whatever level the B of C decides to set it. Because the money supply is fixed by the B of C, therefore, it does not depend on the interest rate. The fixed money supply is represented by a vertical supply curve. 1

2 The Supply and Demand for Money A desire of liquidity describes how people choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services. The Money Demand is determined by several factors. However, the most important is the interest rate. The primary opportunity cost of having the convenience of holding money is the interest income that one gives up when one holds cash or chequing account balances. An increase in the interest rate raises the cost of holding money and thus reduces the quantity of money balances people wish to hold. Equilibrium in the Money Market By the Theory of Liquidity Preference: The interest rate adjusts to balance the supply and demand for money. There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded exactly equals the quantity of money supplied. Theory of Liquidity Preference and the Aggregate Demand Curve The general price level of all goods and services in the economy influences the money demand and interest rates: 1. A higher price level raises money demand (i.e. a shift in the money demand curve.) 2. Higher money demand leads to a higher interest rate. 3. Higher interest rate reduces the quantity of goods and services demanded (AD). Changes in the Money Supply The B of C has control over shifts in the aggregate demand when it changes monetary policy. An increase in the money supply (i.e. buying bonds) will shift the Money Supply to the right without a change in the Money Demand the interest rate will fall, thus inducing people to hold the additional money the B of C has created. Small Open Economy Considerations A monetary injection by the B of C causes the dollar to depreciate, which causes net exports to rise shifting the AD curve to the right. Therefore, B of C must allow the exchange rate to vary freely if its desire is to change the money supply. 2

3 How Fiscal Policy Influences Aggregate Demand 1. Fiscal policy refers to the government s choices regarding the overall level of government purchases or taxes. 2. Fiscal policy influences saving, investment, and growth in the long-run. In the shortrun, fiscal policy affects the aggregate demand. 3. The federal government can influence the economy because of a.) the size of the central government in relation to the economy and other economic entities. b.) the deliberate use of spending and taxes to manipulate the economy toward achieving a predetermined outcome. The Multiplier Effect of Government Purchases Government expenditures have a direct effect on aggregate spending and therefore equilibrium GDP as follow: 1. Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar--- a multiplier effect. 2. The total impact of the quantity of goods and services demanded can be much larger than the initial impulse from higher government spending. 3. The formula for the multiplier is: Multiplier = 1 (1 - MPC) Where MPC is the Marginal Propensity to Consume. The Crowding-Out Effect of Government Purchases An increase in government purchases causes the interest rate to rise, and a higher interest rate tends to choke off the demand for goods and services. The reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. 3

4 Open Economy Considerations In a small, open economy, an expansionary fiscal policy causes the dollar to appreciate. Since this causes net exports to fall, there is an additional crowding-out effect that reduces the demand for Canadian produced goods and services. If the B of C chooses to prevent any change in the exchange rate, an expansionary fiscal policy will have no crowding-out effect and will therefore cause a very large increase in the demand for goods and services. For fiscal policy to have a lasting affect on the position of the aggregate-demand curve, the B of C must choose the appropriate exchange rate policy. Changes in Taxes Taxes and tax policy indirectly affect the aggregate spending of consumers. 1. When the government cuts taxes, it increases households take-home pay 2. Thus results in households saving some of the additional income, but households will spend some on consumer goods, thus shifting the aggregatedemand curve to the right. 3. The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier and crowding-out effects. 4. The duration of the shift in the aggregate demand is also determined by the B of C s policy for the exchange rate (fixed or varied). 4

5 Using Policy to Stabilize the Economy Many policy-makers believe it necessary to use monetary and fiscal policy to achieve any level of aggregate demand and GDP that they wish. Active monetary and fiscal intervention is necessary to tame an inherently unstable private sector. The use of policy instruments stabilize aggregate demand and production and employment. The use of government tax and spending policies to stabilize economic ups and downs in the short-run are called discretionary fiscal policies. Some economists argue that the government should avoid using monetary and fiscal policy to try to stabilize the economy. They suggest the economy should be left to deal with the short-run fluctuations on its own. Automatic Stabilizers Automatic Stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policy-makers having to take any deliberate action. Automatic stabilizers include: 1. The Tax System 2. Government Spending 5

6 The Economy in the Long-Run and Short-Run When thinking about the long-run economy the Loanable Funds Theory is used to best describe the changes that occur. When thinking about the short-run economy, the Liquidity-Preference Theory is used to best describe the changes that occur. In the Long-Run: 1. Output is determined by the supplies of capital and labour and the available production technology. 2. In a closed economy, the interest rate adjusts to balance the supply and demand for loanable funds. 3. The price level adjusts to balance the supply and demand for money. In the Short-Run: 1. The price level is stuck at some level and is relatively unresponsive to changing economic conditions. 2. The interest rate adjusts to balance the supply and demand for money. 3. The level of output responds to changes in the aggregate demand for goods and services. 6