Chapter 21 The influence of monetary and fiscal policy on aggregate demand

Chapter 21 The influence of monetary and fiscal policy on aggregate demand

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Chapter 21 The Influence of Monetary and Fisc- al Policy on Aggregate Demand How Monetary Policy Influences Aggregate Demand There are 3 reasons why the aggregate demand curve slopes downward: 1. The wealth effect -(least important because money holdings are a small part of household wealth) 2. The interest rate effect - (the most important reason) 3. The exchange rate effect - (also not very important because exports and imports represent only a fraction of the U.S. GDP.) Theory of Liquidity Preference Keynes’s theory that the interest rate adjusts to bring money supply and money demand to bal- ance. Money Supply The quantity of money supplied is fixed by the Fed policy , it does not depend on other economic variables such as interest rates, thus the money supply is represented with a vertical supply curve. Money Demand The most emphasized factor that determines the quantity of money demanded is the interest rate. The reason is that the interest rate is the opportunity cost of holding money. When interest rate increases, the cost of holding money increases, money demand decreases. Thus the money de- mand slopes downward. Equilibrium in the Money Market Equilibrium interest rate - where the quantity of money demanded exactly balances the quantity of money supplied. If the interest rate is at any other level, people will try to adjust their portfoli- os of assets and, as a result, drive the interest rate toward the equilibrium. The Downward Slope of the Aggregate Demand Curve 1. Higher price level raises money demand 2. Higher money demand leads to a higher interest rate 3. Higher interest rate reduces the quantity of good and services demanded (less borrowing to in- vest) works in reverse! Changes in the Money Supply h demand curve h
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
When the Fed increases the money supply , it lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting the aggregate demand curve to the right. Conversely, when the Fed
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 07/03/2010 for the course ECON 201 taught by Professor Salehie during the Spring '08 term at University of Washington.

Page1 / 4

Chapter 21 The influence of monetary and fiscal policy on aggregate demand

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online