The influence of monetary

and fiscal policy

On Aggregate Demand
Outline
The influence of (expansionary)
monetary policy on aggregate
demand and on SR fluctuations
The influence of (expansionary) fiscal
policy on aggregate demand and on
SR fluctuations
Case of closed economy
Case of open economy
Fiscal policy and monetary policy
Fiscal policy: The use of the
governments tax and expenditure policies
in an effort to influence the behavior of the
economy (Ex: GDP and total employment).
Monetary policy: The use of monetary
variables such as the money supply , and
rate of interest to influence the behavior of
the economy.
How monetary policy influences
aggregate demand? Case of a closed
economy
Recap:
Aggregate demand curve is downward
sloping due to :
Wealth effect
Interest rate effect
RER effect
In the closed economy, interest effect is
important
In the open economy, RER effect is
important
How monetary policy influences
aggregate demand? Case of a closed
economy
The most important reason for the down-
ward sloping nature of aggregate demand
is the interest rate effect.
Theory of Liquidity Preference explains
that the interest rate (real and nominal)
adjusts to bring money supply and money
demand into equilibrium. Real and nominal
interest rates move together because the
expected rate of inflation is constant in the
SR.
Theory of Liquidity Preference:
Money supply is fixed by the Central Bank and is
independent of the rate of interest.
Money is demanded for its liquidity (medium of
exchange.
Money demand is inversely related to interest rate
at a given price level and output level . Interest rate
represents the opportunity cost of holding money.
Money is demanded for its capability to buy goods
and services.
The $ value of transactions (PY) is the other
important determinant of money and causes shifts
in money demanded at a given interest rate.
Equilibrium in the money market
Interest rate adjusts to balance the supply
and demand for money.
Theory of Liquidity Preference and
Aggregate
Increase inDemand
prices and interest rate effect:
A higher price level increases $ value of
transactions and shifts aggregate demand to
the right. This in turn raises the interest rate
and reduces investment in the economy, which
in turn reduces the quantity of goods and
services demanded.
Interest effect and AD curve (demand for
goods and services)
Increase in prices ---- Increase in demand for
money--- increase in interest rate--- decrease in qty
of goods and services demanded.
Impact of monetary policy on aggregate
demand in the SR: Closed economy
Recall:
Shifts in aggregate demand occur with
changes in consumption, Investment, and Govt
expenditure, net exports at a given price level.
In an open economy, NX=0
Changes in C, I, G, and NX can occur through
fiscal policy or monetary policy.
The Central Bank can change money supply
through:
Open market operations in the bond market and/ or in
the foreign currency exchange market
Changes in the Bank Rate
Impact of monetary policy on aggregate
demand in the SR: Closed economy
Expansionary monetary policy is
implemented by the Central Bank by
increasing the money supply.
The expansionary monetary policy lowers the
interest rate, and increases the quantity of
goods and services demanded for a given
price level.
The contraction monetary policy (Central
Bank contracts money supply) raises the
interest rate and reduces the quantity of
goods and services demanded for a given
price level
How monetary policy influences
aggregate demand? Case of open
Recap:
economy
Interest rate = world interest rate for a small
open economy with perfect capital mobility.
The most important reasons for the down-ward
sloping nature of aggregate demand are the
interest rate effect and the real exchange rate.
Increase in prices and RER effect: A higher
price level increases RER and decreases net
exports, which in turn reduces the quantity of
goods and services demanded.
Expansionary monetary policy in an
open- economy with flexible
Expansionary monetary policy by the Central
exchange rate
Bank depreciates the RER causing net
exports to rise. This increases the demand for
goods and services and shifts the aggregate
demand to the right.
The effect of a monetary injection on
aggregate demand is much stronger in an
open economy as compared to a closed
economy.
Expansionary monetary policy in an
open- economy with fixed exchange
Expansionary monetary policy by the Central
rate
Bank depreciates the RER causing net
exports to rise.
Central bank through open market operations
in the foreign- currency exchange market can
hold the value of the domestic currency
constant. This reduces money supply in the
economy.
The Central Bank cannot simultaneously
choose the size of the money supply and the
value of the currency.
Expansionary fiscal policy and
aggregate demand in the SR: Closed
Recap:
economy
Shifts in aggregate demand at a given price level
occur through changes in C, I, G, and NX.
Fiscal policy influences C and I by altering
spending decisions of households and firms.
Changes in govt expenditure (G)alter aggregate
demand directly.
Increase in govt expenditure--- increases demand
for goods and services- AD shifts to the right.
Govt expenditure and aggregate
demand (AD)
Size of govt expenditure and size of shift in AD
depend on :
Multiplier effect (k)
Crowding-out effect on investment
Crowding-out effect on NX
K effect: additional shifts in the AD that result when
expansionary fiscal policy increases income and thereby
increases consumer expenditure
Crowding-out effect on investment: offset in the AD
that results when expansionary fiscal policy raises the
interest rate and thereby reduces investment expenditure
Crowding-out effect on NX: offset in the AD that results
when expansionary fiscal policy in a small open economy
with flexible exchange rate raises the RER and thereby
reduces net exports
Multiplier effect
Increase in income is spent on consumption and
savings.
K= 1/1-MPC in a closed economy
MPC= Marginal propensity to consume
In a closed economy, k is directly proportional to MPC
K= 1/1-MPC+MPI in an open economy
MPI= Marginal propensity to import
In an open economy, k is indirectly proportional to MPI
In general, the aggregate demand for goods and
services rises by more than the govt expenditure due
to the k effect
Illustration: see example done in class
Crowding-out effect on investment
Increase in govt expenditure causes rise in
rate of interest and reduces residential and
business investment expenditure thus
choking off aggregate demand.
If crowding out effect on investment is larger
than the k effect, then AD for goods and
services will rise by less than govt purchases.
Crowding-out effect on NX
In a small open economy with perfect capital
mobility, increase in govt expenditure causes
a rise in the rate of interest thus raising
domestic interest rate above the world
interest rate.
If the exchange rate is flexible, this causes an
appreciation in the RER and reduces net
exports and thereby the aggregate demand
for goods and services.
Fiscal policy and effect on aggregate
demand in a closed economy
Expansionary fiscal policy is undertaken
through an increase in govt expenditure on
public works/ job creation programs.
The size of shift in AD depends on the size of
the k and the size of the crowding-out effect
on investment.
An increase in govt purchases increases the
demand for goods and services by the value
of the k thus raising the demand for money
and interest rate. The rise in interest rate
crowds out investment and AD shifts to the
left at a given price level.
Fiscal policy and effect on aggregate
demand in an open economy: Flexible
exchange rate
In a small open economy, expansionary fiscal
policy causes
Crowding out effect on investment due to an
increase in domestic interest rate (> than world
interest rate)
crowding out effect on NX due to an appreciation
in the RER.
Expansionary fiscal policy has no lasting
effect on on the position of the aggregate
demand curve
Fiscal policy and effect on aggregate
demand in an open economy: Fixed
exchange
In a smallrate
open economy, expansionary fiscal policy
causes domestic interest rate to rise above world interest
rate. This appreciates the RER.
The Central Bank through open market operations in the
foreign currency exchange market (purchase of foreign
currency) increases the supply of domestic currency and
prevents changes in the exchange rate.
Thus, the Bank prevents crowding out effect on NX.
The supply of domestic currency by the Central bank
causes domestic interest rate to fall and equal world
interest rate.
Thus, the Bank prevents crowding out effect on
investment.
The increase in money supply shifts the AD curve even
farther to the right.
Fiscal policy and effect on aggregate
demand in an open economy: Fixed
exchange rate exchange rate, an expansionary
With a fixed
fiscal policy will have no crowding-out effects
and will therefore cause a large increase in
the demand for goods and services.
Coordination of Monetary and Fiscal policy

For fiscal policy to have a lasting effect on the

AD curve, the Central Bank must choose the
appropriate exchange rate policy.
Changes in taxes: reduction in taxes
stimulates consumer expenditure through the
multiplier effect
crowds out net exports by increasing RER
Deficit reduction
Balanced budget limits the governments options to
increase AD.
Deficit reduction will have no long lasting impact on
AD in the event of a flexible exchange rate policy.
Stabilization Policy

In theory, monetary policy and fiscal policy can be

used to stabilize (offset) the effects of shocks to the
Canadian economy.
Identifying the shock and its affects and determining
an appropriate response is often difficult.
Monetary policy, although quickly implemented,
affects the economy with considerable lags ( 1/2 to
1 1/2 years).
Fiscal policy has a long implementation lag. Effects
of policies are themselves uncertain.
Stabilization Policy: Current situation
Active fiscal policy rarely used for aggregate demand
management.
Monetary policys primary focus is to maintain an inflation
target while minimizing the effects of monetary policy on
aggregate demand.
Automatic stabilizers in place to minimize AD fluctuations.
Taxes and transfers: when AD is low, taxes fall and
transfers increase offsetting some of the low AD.
Flexible exchange rate: an external AD shock (fall/rise in
NX) is offset by exchange rate adjustment.