Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand

    In developing a theory of short run economic fluctuation, Keynes proposed the theory of liquidity preference to explain the determinants of the interest. According to this theory, the interest rate adjusts to balance the supply and demand for money.

    An increase in the price level raises money demand and increases the interest rate that bring the market into equilibrium. Since the interest rate represents the costs of borrowing, a higher interest rate reduces investment and quantity of goods and services demanded.

    Policymakers can influence aggregate demand with monetary policy, as an increase nion the money supply reduces the equilibrium interest rate for any given price. Since a lower interest rate stimulates investment spending, the aggregate demand curve shifts to the right. Fiscal policy could also be utilized to influence aggregate demand. Increases in government purchases of cuts in taxes shifts the demand curve to the right, whereas a decrease in government purchases or increase in taxes shifts the aggregate demand curve to the left.

When the government alters spending or taxes, the resulting shift in demand can be larger or smaller than the fiscal change, and the multiplier effect tends to amplify the effects of fiscal policy on aggregate demand. But, the bow dining out effect tends to dampen the effects of fiscal policy on aggregate demand.

Since monetary and fiscal policy can influence aggregate demand, the government sometimes uses these policy instruments in an attempt to stabilize the economy. Economists disagree about how active the government should be in this. According to advocates of active stabilization policy, changes in attitudes byu households and firms shift aggregate demand, but if the government does not respond, the result is undesirable and unnecessary fluctuations in output employment. According to critics of active stabilization policy, monetary and fiscal policy work with such long lags that attempts at stabilizing the economy often end up destabilizing it.

   

Chapter 33: Aggregate Demand and Aggregate Supply

Chapter 33 is about aggregate supply and aggregate demand. The model is used to explain short-run fluctuations in economic activity around its long run trend. The aggregate demand curve shows the quantity of food and services that households, firms, the government, and customers abroad want to buy at each price level, and the supply curve is the quantity of goods and services that firms choose to produce and sell at each price level.

Short run fluctuations are unpredictable, and these recessions cause real GDP as well as income, spending, and production falls, and unemployment rises. According to the model, the output of goods and services and overall level of prices adjust to balance aggregate demand and supply. The aggregate demand curve slopes downward because of the wealth effect, the interest rate effect, and the exchange rate effect. The wealth effect states that a lower price level raises the real value of household money holdings, stimulating consumer spending. The interest effect states that a lower price level reduces the quantity of money demanded, and as households convert money into interest bearing assets, interest rates fall, stimulating investment spending. The exchange rate effect states that as a lower price level reduces interest rates, the dollar depreciates, stimulating net exports.

Aggregate demand could be affected by any event or policy that raises consumption, investment, government purchases, or net exports at a given price level.

Long run aggregate supply is vertical; the quantity of goods and services supplied depends on the economy’s labor, capital, natural resources, and technology.