Discuss how monetary and fiscal policy are used to influence aggregate

demand of an economy.

Definition of terms:

Monetary policy

Monetary policy is how central banks manage liquidity to create economic

growth. Liquidity is how much there is in the money supply. That
includes credit, cash, checks, and money market mutual funds. The most
important of these is credit. It includes loans, bonds, and mortgages. 

Monetary policy is the macroeconomic policy laid down by the central bank. It
involves management of money supply and interest rate and is the demand side
economic policy used by the government of a country to achieve macroeconomic
objectives like inflation, consumption, growth and liquidity.

Monetary policy is the process by which the monetary authority of a country, typically
the central bank or currency board, controls either the cost of very short-term borrowingor
the monetary base, often targeting an inflation rate or interest rate to ensure price stability and
general trust in the currency.

Monetary policy is referred to as being either expansionary or contractionary. Expansionary

policy is when a monetary authority uses its tools to stimulate the economy. An expansionary
policy maintains short-term interest rates at a lower than usual rate or increases the total supply
of money in the economy more rapidly than usual. It is traditionally used to try to
combat unemployment in a recession by lowering interest rates in the hope that less expensive
credit will entice businesses into expanding. This increases aggregate demand (the overall
demand for all goods and services in an economy), which boosts short-term growth as measured
by gross domestic product (GDP) growth. Expansionary monetary policy usually diminishes the
value of the currency relative to other currencies (the exchange rate).[5]
The opposite of expansionary monetary policy is contractionary monetary policy, which maintains
short-term interest rates higher than usual or which slows the rate of growth in the money supply
or even shrinks it. This slows short-term economic growth and lessens inflation. Contractionary
monetary policy can lead to increased unemployment and depressed borrowing and spending by
consumers and businesses, which can eventually result in an economic recession if implemented
too vigorously.

Types of Monetary Policy

Central banks use contractionary monetary policy to reduce inflation. They
have many tools to do this. The most common are raising interest rates and
selling securities through open market operations.

They use expansionary monetary policy to lower unemployment and

avoid recession. They lower interest rates, buy securities from member banks,
and use other tools to increase liquidity. 

Fiscal policy

Fiscal policy can be defined as government�s actions to influence an economy

through the use of taxation and spending. This type of policy is used when policy-
makers believe the economy needs outside help in order to adjust to a desired point.
Typically a government has a desire to maintain steady prices, an employment level,
and a growing economy. If any of these areas are out of sorts, some type of fiscal
policy may be in order.

Fiscal policy involves the government changing the levels of

taxation and government spending in order to influence Aggregate
Demand (AD) and the level of economic activity.

Aggregate demand

aggregate demand is the total number of final goods and services in an economy,
which include consumption, investment, government spending, and net exports.

Aggregate Demand = Consumption + Investment + Govt Spending + Net

Exports
Aggregate demand is an economic measurement of the sum of all final goods
and services produced in an economy, expressed as the total amount of
money exchanged for those goods and services. Since aggregate demand is
measured by market values, it only represents total output at a given price
level and does not necessarily represent quality or standard of living.

Shifting AD to the Left

The aggregate demand curve tends to shift to the left when total consumer

spending declines. Consumers might spend less because the cost of living is rising
or because government taxes have increased. Consumers may decide to spend less
and save more if they expect prices to rise in the future. It might be that consumer
time preferences change and future consumption is valued more highly than present
consumption.

It is not clear whether an increase in savings necessarily shifts AD to the left.

Demand might remain unchanged if those extra savings become loans to
businesses and then total business spending on capital goods increases.

Contractionary fiscal policy can shift aggregate demand to the left. The government

might decide to raise taxes and/or decrease spending to fix a budget
deficit. Monetary policy has less immediate effects. If monetary policy raises the
interest rate, individuals and businesses tend to borrow less and save more. This
could shift AD to the left.

Shifting AD to the Right

For every possible cause of a leftward shift in the AD curve, there is an opposite
possible rightward shift. Increased consumer spending on domestic goods and
services can shift AD to the right. It is possible that a declining marginal propensity to
save (MPS) can also shift AD to the right. Expansionary monetary and fiscal policy
might increase aggregate demand. All of these effects are the inverse of the factors
that tend to decrease aggregate demand.

Economy

Expansionary Fiscal Policy

 When an economy is in a recession, expansionary fiscal policy is in order. Typically
this type of fiscal policy results in increased government spending and/or lower
taxes. A recession results in a recessionary gap � meaning that aggregate demand
(ie, GDP) is at a level lower than it would be in a full employment situation. In order
to close this gap, a government will typically increase their spending which will
directly increase the aggregate demand curve (since government spending creates
demand for goods and services). At the same time, the government may choose to
cut taxes, which will indirectly affect the aggregate demand curve by allowing for
consumers to have more money at their disposal to consume and invest. The actions
of this expansionary fiscal policy would result in a shift of the aggregate demand
curve to the right, which would result closing the recessionary gap and helping an
economy grow.

Contractionary Fiscal Policy

Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy.

When an economy is in a state where growth is at a rate that is getting out of control
(causing inflation and asset bubbles), contractionary fiscal policy can be used to rein
it in to a more sustainable level. If an economy is growing too fast or for example, if
unemployment is too low, an inflationary gap will form.

In order to eliminate this inflationary gap a government may reduce government

spending and increase taxes. A decrease in spending by the government will directly
decrease aggregate demand curve by reducing government demand for goods and
services. Increases in tax levels will also slow growth, as consumers will have less
money to consume and invest, thereby indirectly reducing the aggregate demand
curve.

Expansionary (or loose) Fiscal Policy

 This involves increasing AD.

 Therefore the government will increase spending (G) and cut taxes
(T). Lower taxes will increase consumers spending because they have
more disposable income (C)

 This will tend to worsen the government budget deficit, and the
government will need to increase borrowing.
Monetary Policy

Changes in the money supply

An increase in the money supply will lead to in increase in the amount of money that people
and firms will hold and they will spend more. Therefore aggregate demand will increase. The
reverse will be true when money supply decreases. That is a decrease in the money supply
will lead to a decrease in the amount of money that people and firms will hold and as a result
they will spend less. This will cause aggregate demand to decrease.

The demand for money can be in several ways.

1. Transactions demand for money: the demand for money for exchange purposes is
called transactions demand for money. If the transaction is very high then the quantity
of money demanded for transaction is high too. Therefore, the transaction demand for
money is seen as money�s role as a medium of exchange. It is also a store of value.

There are two ways in which people can store their purchasing power

a. in the form of money

b. in the form of other financial assets such as private and government securities

1. Precautionary demand for money: that is to hold money for unexpected expenditures,
and emergencies.

The precautionary demand for money varies directly with nominal national income
and inversely with the interest rate.

2. Asset demand or Speculative demand for money: the demand for money balances that
people desire as a store of value. This kind of demand for money people wishes to
 hold because of its liquidity and lack of risk. The asset demand for money varies
inversely with the interest rate.

Money demand for money and interest rate are inversely related

The demand for money slopes downward because as interest rate declines, the opportunity
cost of holding money will decline too. Therefore, the quantity of money demanded will
increase.

The effects of an increase in the money supply:

When the money supply increases, people will have excess money to spend and two things
can happen

1. Direct effect of an increase in the money supply: That is some people will demand
more goods and services.

2. Indirect effect of an increase in the money supply: that is some people will deposit
some of their money in banks. Therefore, excess reserves will increase and banks will
want to lend more. Banks will lower interest rate to motivate borrowing. This will
increase investment and consumption and therefore aggregate demand will increase.

The supply of money (stock of money) in the economy is determined by the Fed through its
control over excess reserves in the banking system. The supply of money is vertical which
implies that quantity of money supplied is independent of the interest rate.

If the Fed increases the Money supply then Money supply curves shifts to the right. The
quantity demanded at the original interest rate, because of the increases supply of money,
there is now more money in the hands of the public, so people are able to hod a greater
quantity of money.

Monetary policy influences the market interest rate, which affects the level of planned
investment.

If the Fed believes that the economy is operating well below its potential level of output and
decides to increase the Money supply to stimulate output and employment.

The Fed can expand the money supply by:

1. purchasing U.S. government securities

2. Lowering the interest rate at which banks can borrow from the Fed.

3. Lowering Reserve Requirements

The equation of exchange: M*V = P*Q

M is money supply, V is the velocity of money which is the average number of times per year
a dollar is used to buy final goods and services, P is the price level, Q is the nominal income
or output.

If the quantity of money is stable or at least predictable, then changes in the money supply
have predictable effects on nominal income. That is if money supply increases by 5% and V
is constant then P*Y must increase by 5%.

Monetary Policy and Aggregate Demand

Monetary policy affects interest rates and the available quantity of loanable funds,
which in turn affects several components of aggregate demand. Tight or
contractionary monetary policy that leads to higher interest rates and a reduced
quantity of loanable funds will reduce two components of aggregate demand.
Business investment will decline because it is less attractive for firms to borrow
money, and even firms that have money will notice that, with higher interest rates, it
is relatively more attractive to put those funds in a financial investment than to make
an investment in physical capital. In addition, higher interest rates will discourage
consumer borrowing for big-ticket items like houses and cars. Conversely, loose or
expansionary monetary policy that leads to lower interest rates and a higher quantity
of loanable funds will tend to increase business investment and consumer borrowing
for big-ticket items.

If the economy is suffering a recession and high unemployment, with output

below potential GDP, expansionary monetary policy can help the economy return to
potential GDP. Figure 14.8 (a) illustrates this situation. This example uses a short-
run upward-sloping Keynesian aggregate supply curve (AS). The original equilibrium
during a recession of Er occurs at an output level of 600. An expansionary monetary
policy will reduce interest rates and stimulate investment and consumption spending,
causing the original aggregate demand curve (AD 0) to shift right to AD1, so that the
new equilibrium (Ep) occurs at the potential GDP level of 700.
Figure 14.8. Expansionary or Contractionary Monetary Policy. (a) The economy is originally in a recession
with the equilibrium output and price level shown at Er. Expansionary monetary policy will reduce interest
rates and shift aggregate demand to the right from AD0 to AD1, leading to the new equilibrium (Ep) at the
potential GDP level of output with a relatively small rise in the price level. (b) The economy is originally
producing above the potential GDP level of output at the equilibrium Ei and is experiencing pressures for
an inflationary rise in the price level. Contractionary monetary policy will shift aggregate demand to the left
from AD0 to AD1, thus leading to a new equilibrium (Ep) at the potential GDP level of output.

Conversely, if an economy is producing at a quantity of output above its potential

GDP, a contractionary monetary policy can reduce the inflationary pressures for a
rising price level. In Figure 14.8 (b), the original equilibrium (Ei) occurs at an output
of 750, which is above potential GDP. A contractionary monetary policy will raise
interest rates, discourage borrowing for investment and consumption spending, and
cause the original demand curve (AD0) to shift left to AD1, so that the new equilibrium
(Ep) occurs at the potential GDP level of 700.
These examples suggest that monetary policy should be countercyclical; that is, it
should act to counterbalance the business cycles of economic downturns and
upswings. Monetary policy should be loosened when a recession has caused
unemployment to increase and tightened when inflation threatens. Of course,
countercyclical policy does pose a danger of overreaction. If loose monetary policy
seeking to end a recession goes too far, it may push aggregate demand so far to the
right that it triggers inflation. If tight monetary policy seeking to reduce inflation goes
too far, it may push aggregate demand so far to the left that a recession
begins. Figure 14.9 (a) summarizes the chain of effects that connect loose and tight
monetary policy to changes in output and the price level.
Figure 14.9. The Pathways of Monetary Policy. (a) In expansionary monetary policy the central bank
causes the supply of money and loanable funds to increase, which lowers the interest rate, stimulating
additional borrowing for investment and consumption, and shifting aggregate demand right. The result is a
higher price level and, at least in the short run, higher real GDP. (b) In contractionary monetary policy, the
central bank causes the supply of money and credit in the economy to decrease, which raises the interest
rate, discouraging borrowing for investment and consumption, and shifting aggregate demand left. The
result is a lower price level and, at least in the short run, lower real GDP.

Monetary Policy
Monetary policy is enacted by central banks by manipulating the money supply in an
economy. The money supply influences interest rates and inflation, both of which are
major determinants of employment, cost of debt and consumption levels.
Expansionary monetary policy entails a central bank either buying Treasury notes,
decreasing interest rates on loans to banks or reducing the reserve requirement. All
of these actions increase the money supply and lead to lower interest rates. This
creates incentives for banks to loan and businesses to borrow. Debt-funded
business expansion positively affects consumer spending and investment through
employment, thereby increasing aggregate demand. (For related reading, see: What
are some examples of expansionary monetary policy?)

Expansionary monetary policy also typically makes consumption more attractive

relative to savings. Exporters benefit from inflation as their products become
relatively cheaper for consumers in other economies.

Contractionary monetary policy is enacted to halt exceptionally high inflation rates or

normalize the effects of expansionary policy. Tightening the money supply
discourages business expansion and consumer spending and negatively impacts
exporters, reducing aggregate demand.
Examples of expansionary monetary policy are decreases in the discount rate,
purchases of government securities and reductions in the reserve ratio. All of these
options have the same purpose—to expand the country's money supply.

This is a tool employed by central banks to stimulate the economy during

a recession or in anticipation of a recession. Expanding the money supply results in
lower interest rates and borrowing costs, boosting consumption and investment.

When interest rates are already high, the central bank focuses on lowering
the discount rate. As this rate falls, corporations and consumers are able to borrow
more cheaply. The declining interest rate makes government bonds and savings
accounts less attractive, encouraging investors and savers toward risk assets.

When interest rates are already low, there is less room for the central bank to cut
discount rates. In this case, central banks purchase government securities. This is
known as quantitative easing (QE). QE stimulates the economy by reducing the
number of government securities in circulation. The increase of money relative to a
decrease in securities creates more demand for existing securities, lowering interest
rates and encouraging risk-taking.

The reserve ratio is a tool used by central banks to increase loan activity. During
recessions, banks are less likely to loan money and consumers are less likely to
pursue loans due to economic uncertainty. The central bank seeks to encourage
increased lending by banks by decreasing the reserve ratio, which is essentially the
amount of capital a bank needs to hold onto when making loans.