N.

Gregory Mankiw

Principles of
Economics Sixth Edition

34 Chapter 35 in
middle east edition

The Influence of Monetary &

Fiscal Policy on Aggregate
Demand
Introduction
 This chapter focuses on the short-run effects
of fiscal and monetary policy,
which work through aggregate demand.
 The aggregate demand curve tells us the quantity of all
goods & services demanded in the economy at any given
price level.
 An economy’s GDP (Y) is the sum of consumption (C),
investment (I), government (G) purchases & net exports
(NX)
 Each of the four components of GDP contributes to the
aggregate demand for goods & services.
 The aggregate demand curve slopes downward. Why?
 Why the AD Curve Slopes Downward

Y = C + I + G + NX P

Assume G fixed
P2
by govt policy.
To understand
the slope of AD,
P1
must determine
how a change in P AD
affects C, I, and NX.
Y
Y2 Y1

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Aggregate Demand
 The AD curve slopes downward for three
reasons:
 The wealth effect the most important
 The interest-rate effect of these effects
 The exchange-rate effect
The Wealth Effect (P and C )
Suppose P rises.
 The money people hold buy fewer goods &
services,
so real wealth is lower.
 People feel poorer.
Result: C falls.
Conversely, a lower price level raises the real
value of HH money holdings i.e. higher real
wealth which in turn stimulates consumer
spending i.e. C increases
The Interest-Rate Effect (P and I )
Suppose P rises.
 Buying goods & services requires more money.
 To get this money, people sell bonds or other assets.
 This drives up interest rates.
Result: I falls.

Conversely, a lower price level lowers ‘r’ , as people try to

lend out their excess money holdings. This reduction in ‘r’
stimulates investment spending. i.e. I increases

(Recall, I depends negatively on interest rates.)

 The Exchange-Rate Effect (P and NX )
Suppose P rises in Egypt.
 Egypt’s interest rates rise (the interest-rate effect).
 Foreign investors desire more of Egypt’s bonds.
 Higher demand for EGP (or higher supply of foreign currencies for
EGP in the foreign exchange market).
 EGP exchange rate appreciates & other foreign currencies
depreciate.
 Egyptian exports become more expensive to people abroad, imports
cheaper to Egyptian residents.
 Result: NX falls because exports decrease & imports increase.
Conversely, when a lower price level lowers ‘r’, investors move some of
their funds overseas causing domestic currency to depreciate relative
to foreign currencies. This makes domestic goods relatively cheaper;
exports increase & imports decrease.
Thus NX increases.
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The Slope of the AD Curve: Summary
An increase in P P
reduces the quantity
of goods & services P2
demanded because:
 the wealth effect
(C falls)
P1
 the interest-rate
AD
effect (I falls)
 the exchange-rate Y
Y2 Y1
effect (NX falls)

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 Why the AD Curve Might Shift
Any event that changes
C, I, G, or NX—except P
a change in P—will shift
the AD curve.
Example: P1
A stock market boom
makes households feel
wealthier, C rises, AD2
AD1
the AD curve shifts right.
Y
Y1 Y2
What happens to the AD curve in each of the
following scenarios?

A. A ten-year-old investment tax credit expires.

I falls, AD curve shifts left.
B. The U.S. exchange rate falls.
NX rises, AD curve shifts right.
C. A fall in prices increases the real value of
consumers’ wealth.
Move down along AD curve (wealth-effect).
 The Interest rate effect & The Theory of
Liquidity Preference
• Keynes developed the theory of liquidity
preference to explain what factors determine
the economy’s interest rate (denoted r)
• According to the theory, the interest rate
adjusts to balance the supply and demand
for money.
 Money supply: assumed fixed by central bank,
i.e. does not depend on interest rate

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 The Theory of Liquidity Preference

Money Demand
•Money demand reflects how much wealth people want to hold in liquid
form.
•Any asset’s liquidity refers to the ease with which that asset can be
converted into the economy’s medium of exchange which can be used
to buy goods and services.

•Since money is the medium of exchange, it is the most liquid asset.

This liquidity explains demand for money i.e. why people prefer to hold
money instead of any other asset that may offer a higher rate of return.

•The opportunity cost of holding money is the interest that could be

earned on interest-earning assets.

•An increase in the interest rate raises the opportunity cost of holding
money. As a result, the quantity of money demanded is reduced.
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 The Theory of Liquidity Preference
 For simplicity, suppose household wealth
includes only two assets:
 Money – liquid but pays no interest
 Bonds – pay interest but not as liquid
 A household’s “money demand” reflects its
preference for liquidity.
 The variables that influence money demand:
Y, r, and P.

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 Determinants of Money demand:
Real Income
 Suppose real income (Y) rises. Other things
equal, what happens to money demand?
 If Y rises:
 Households want to buy more goods &
services,
so they need to hold more money.
 i.e. an increase in Y causes
an increase in money demand, other things equal.

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 Determinants of Money demand:
The interest rate

A. Suppose r rises, but Y and P are unchanged.

What happens to money demand?
r is the opportunity cost of holding money.
An increase in r reduces money demand:
households attempt to buy bonds to take
advantage of the higher interest rate.
Hence, an increase in r causes a decrease in
money demand, other things equal.

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 Determinants of Money demand

B. Suppose P rises, but Y and r are unchanged.

What happens to money demand?
If Y is unchanged, people will want to buy the
same amount of g&s.
Since P is higher, they will need more money to
do so.
Hence, an increase in P causes an increase
in money demand, other things equal.

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 Equilibrium in the Money Market -
How r is determined

Interest
MS MS curve is vertical:
rate
Changes in r do not
affect MS, which is
r1
fixed by the Fed.
Eq’m MD curve is
interest downward sloping:
rate MD1 A fall in r increases
money demand.
M
Quantity fixed
by the Fed
 Equilibrium in the Money Market
• if ‘r’ is lower than equilibrium, the quantity of money people want to hold
(MD) > MS.
•People try to increase their holdings of money by reducing their holdings of
other interest-bearing assets e.g. bonds.
•This will induce bond issuers to offer higher ‘r’ to attract buyers.
•As ‘r’ rises, people become less willing to hold money until the point where MS
= MD

•if ‘r’ is higher than equilibrium ‘r’, the quantity of money people want to hold
(MD ) < MS.
• People who are holding this surplus of money will try to decrease their
holdings of money by increasing their holdings of other interest-bearing assets
e.g. bonds.
•Because bond issuers prefer to pay lower ‘r’, they lower ‘r’ on their assets.
• As ‘r’ falls, people become more willing to hold money until the point where
MD = MS.

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 The Interest Rate Effect & The Downward Slope of the
Aggregate Demand Curve

What is the implication of the liquidity preference theory

for the aggregate demand for goods & services?
• The price level is one determinant of the quantity of
money demanded.
• A higher price level increases the quantity of money
demanded MD for any given interest rate.
• Higher money demand leads to a higher interest rate.
• At higher ‘r’, the cost of borrowing & the return to saving
are greater. More HH choose to save & less business
investment takes place. The quantity of goods and
services demanded & the level of output fall.

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 The Money Market and the Slope of the
Aggregate-Demand Curve

(a) The Money Market (b) The Aggregate-Demand Curve

Interest Money Price

Rate supply Level
2. . . . increases the
demand for money . . .

r2 P2
Money demand at
price level P2 , MD2
r 1. An P
3. . . .
which increase
Money demand at in the Aggregate
increases
price level P , MD price demand
the
equilibrium 0 level . . . 0
Quantity fixed Quantity Y2 Y Quantity
interest
by the Fed of Money of Output
rate . . .
4. . . . which in turn reduces the quantity
of goods and services demanded.

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 The Interest Rate Effect & The Downward
Slope of the Aggregate Demand Curve
• A lower price level, reduces MD
• Lower MD, reduces ‘r’
• Lower ‘r’ reduces savings (hence increasing
demand for goods & services) and increases
business investment borrowing and NX.
• Thus increasing the level of output.

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How the Interest-Rate Effect Works
A fall in P reduces money demand, which lowers r.
Interest P
rate MS

r1
P1

r2 P2
MD1 AD
MD2
M Y1 Y2 Y

A fall in r increases I and the quantity of g&s demanded.

 The Influence of Monetary & Fiscal Policy
on Aggregate Demand

• Desired spending by households and business

firms determines the overall demand for goods and
services.
• When desired spending changes, aggregate
demand shifts, causing short-run fluctuations in the
economy’s overall output of goods and services
and its overall level of prices.
• Monetary and fiscal policies are used to offset
those shifts and stabilize the economy.

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 Monetary Policy & Aggregate Demand
• The quantity theory of money states that the central
bank, which controls the money supply, has the
ultimate control over the inflation rate.
• If the central bank keeps the money supply stable,
the price level will be stable. If the central bank
increases the money supply rapidly, the price level
will rise rapidly.

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 Monetary Policy and Aggregate Demand
 To achieve macroeconomic goals, the Fed can
use monetary policy to shift the AD curve.
 The Fed’s policy instrument is MS.
• When the Fed increases the money supply, it lowers
the interest rate and increases the quantity of goods and
services demanded at any given price level, shifting
aggregate-demand to the right.
• When the Fed contracts the money supply, it raises
the interest rate and reduces the quantity of goods and
services demanded at any given price level, shifting
aggregate-demand to the left.

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 The Effects of a Monetary Injection

(a) The Money Market (b) The Aggregate-Demand Curve

Interest Price
Rate Money MS2 Level
supply,
MS

r 1. When the Fed P

increases the
money supply . . .
2. . . . the r2
AD2
equilibrium
interest rate Money demand Aggregate
falls . . . at price level P demand, AD
0 Quantity 0 Y Y Quantity
of Money of Output
3. . . . which increases the quantity of goods
and services demanded at a given price level.

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 The Effects of Reducing the Money Supply
The Fed can raise r by reducing the money supply.
Interest P
rate MS2 MS1

r2
P1
r1
AD1
MD AD2
M Y2 Y1 Y

An increase in r reduces the quantity of g&s demanded.

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 The Effects of Reducing the Money Supply
The Fed can raise r by reducing the money supply.
Interest P
rate MS2 MS1

r2
P1
r1
AD1
MD AD2
M Y2 Y1 Y

An increase in r reduces the quantity of g&s demanded.

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 Monetary policy

For each of the events below,

- determine the short-run effects on output
- determine how the Fed should adjust the money
supply and interest rates to stabilize output
A. The government tries to balance the budget by
cutting its own spending (G).
This event would reduce aggregate demand
and output.
To stabilize output, the Fed should increase MS
and reduce r to increase aggregate demand.

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 Monetary policy

For each of the events below,

- determine the short-run effects on output
- determine how the Fed should adjust the money
supply and interest rates to stabilize output
B. A stock market boom increases household
wealth.
This event would increase aggregate demand,
raising output above its natural rate.
To stabilize output, the Fed should reduce MS
and increase r to reduce aggregate demand.

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 Monetary policy

For each of the events below,

- determine the short-run effects on output
- determine how the Fed should adjust the money
supply and interest rates to stabilize output
C. War breaks out in the Middle East,
causing oil prices to soar.
This event would reduce aggregate supply,
causing output to fall.
To stabilize output, the Fed should increase MS
and reduce r to increase aggregate demand.

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 Fiscal Policy and Aggregate Demand
 Fiscal policy:
 the setting of the level of gov’t spending (G), and
 taxation (T) by gov’t policymakers
 Expansionary fiscal policy
 an increase in G and/or decrease in T,
shifts AD right
 Contractionary fiscal policy
 a decrease in G and/or increase in T,
shifts AD left
 Fiscal policy has two effects on AD...
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 1. The Multiplier Effect
 Each $1 increase in G can generate more than a $1 increase in
aggregate demand.
 Example: If the gov’t buys $20b of planes from Boeing,
Boeing’s revenue increases by $20b.
 This is distributed to Boeing’s workers (as wages) and
owners (as profits or stock dividends).
 These people are also consumers and will spend a
portion of the extra income.
 This extra consumption causes further increases in
aggregate demand.
Multiplier effect: the additional shifts in AD
that result when fiscal policy increases income
and thereby increases consumer spending
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 1. The Multiplier Effect

A $20b increase in G P
initially shifts AD
to the right by $20b.
AD2 AD3
The increase in Y AD1
causes C to rise,
P1
which shifts AD
further to the right. $20 billion

Y1 Y2 Y3 Y

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 The Multiplier & the Marginal Propensity to Consume

 How big is the multiplier effect?

It depends on how much consumers respond to increases
in income.
 Marginal propensity to consume (MPC):
the fraction of extra income that households consume
rather than save
e.g., if MPC = 0.8 and income rises $100,
C rises $80.
Multiplier = 1 / (1 –MPC)
1
Y = G
1 – MPC
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 A Formula for the Multiplier
The size of the multiplier depends on MPC.
E.g., if MPC = 0.5 multiplier = 2
if MPC = 0.75 multiplier = 4
if MPC = 0.9 multiplier = 10

A bigger MPC means

changes in Y cause
1
Y = G bigger changes in C,
1 – MPC
which in turn cause
The multiplier bigger changes in Y.

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 2. The Crowding-Out Effect
 Fiscal policy has another effect on AD
that works in the opposite direction.
 A fiscal expansion raises r,
which reduces investment,
which reduces the net increase in aggregate
demand.
 So, the size of the AD shift may be smaller than
the initial fiscal expansion.
 This is called the crowding-out effect.

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 How the Crowding-Out Effect Works (ignoring the
multiplier effect)

A $20b increase in G initially shifts AD right by $20b

Interest P
rate MS

AD AD2
r2 AD1 3

P1
r1
MD2 $20 billion

MD1
M Y1 Y3 Y2 Y

But higher Y increases MD and r, which reduces AD.

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 Fiscal Policy - Changes in Taxes
 A tax cut increases households’ take-home pay.
 Households respond by spending a portion of this
extra income, shifting AD to the right.
 The size of the shift is affected by the multiplier
and crowding-out effects.
 Another factor: whether households perceive the
tax cut to be temporary or permanent.
 A permanent tax cut causes a bigger increase
in C—and a bigger shift in the AD curve—than
a temporary tax cut.
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 Fiscal policy effects

The economy is in recession.

Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = 0.8 and there is no crowding out,
how much should Congress increase G
to end the recession?
Multiplier = 1/(1 – 0.8) = 5
Increase G by $40b
to shift aggregate demand by 5 x $40b =
$200b.
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 How to find the change in G needed to get out of
the recession:
Y = 200 b MPC = 0.8
Multiplier = 1/ (1-MPC) =1/1-0.8 = 5

1
Y = G
1 – MPC
200= 5 x G
The multiplier
200/5 = G

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 Fiscal policy effects

The economy is in recession.

Shifting the AD curve rightward by $200b
would end the recession.
B. If there is crowding out, will Congress need to
increase G more or less than this amount?
Crowding out reduces the impact of G on AD.
To offset this, Congress should increase G by
a larger amount.

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