Chapter 20 The Influence of Monetary and

Fiscal Policy on Aggregate Demand

How Monetary Policy Influences Aggregate

Demand
How Fiscal Policy Influences Aggregate
Demand
Using Policy to Stabilize the Economy

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 In this chapter, we will see how the tools of monetary and
fiscal policy can shift the aggregate-demand curve and, in
doing so, affect short-run economic fluctuations.
Many factors influence AD, including desired spending by
households and business firms. When desired spending
changes, shifts in the AD cause short-run fluctuations in
output and employment.
Monetary and Fiscal policy are used to stabilize the
economy during these fluctuations.
The Aggregate Demand curve is downward sloping due to
three effects: ( See Chapter 19)
Pigous Wealth Effect
Keyness Interest-Rate Effect
Real Exchange-Rate Effect
Of these three effects, the Keyness Interest-Rate Effect2 is
most important.
 Theory of Liquidity Preference: Keyness theory that the
interest rate adjusts to bring money supply and money
demand into balance.
In this chapter, we assume the expected rate of inflation is
constant in the short run. So, when the nominal interest rate
rises or falls, the real interest rate that people expect to earn
rises or falls as well. The real and nominal interest rate
move in the same direction.
The Money Supply is controlled by the B of C, which alters
the money supply in three ways:
Open-Market Operations
Changing the Bank Rate
Buying and selling Canadian dollars in the market for
foreign-currency exchange
The quantity of money supplied in the economy is fixed at
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whatever level the B of C decides to set it.
 Because the money supply is fixed by the B of C it does not
depend on the interest rate.
The fixed money supply is represented by a vertical supply
curve. See Figure 20-1.
By using the Open-Market Operations the B of C can shift
the vertical money supply curve left or right.
If the B of C buys government bonds:
Bank reserves increase and the money supply increases.
If the B of C sells government bonds:
Bank reserves decrease and the money supply declines.
The Money Demand is determined by several factors.
However, the most important is the interest rate.
People choose to hold money instead of other assets that
offer higher rates of return because money can be used to
buy goods and services. (i.e. a desire of liquidity) 4
 Assets liquidity refers to the ease with which that asset is
converted into the economys medium of exchange.
The primary opportunity cost of having the convenience of
holding money is the interest income that one gives up
when one holds cash or chequing account balances.
An increase in the interest rate raises the cost of holding
money and thus reduces the quantity of money balances
people wish to hold. See Figure20-2.

Shift in the demand for money: See Figure 20-3

Shift the demand to the right if the dollar value of
transactions increases because of an increase in either
prices or GDP for any interest rate.
Shift the demand to the left if the dollar value of
transactions decreases because of an decrease in either
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prices or GDP for any interest rate.
 Equilibrium in the Money Market: By the Theory of
Liquidity Preference:
The interest rate adjusts to balance the supply and
demand for money.
There is one interest rate, called the equilibrium interest
rate, at which the quantity of money demanded exactly
equals the quantity of money supplied.
See Figure 20-4. If the interest rate is above the equilibrium
level (such as at r1), the quantity of money people want to
hold is less than the quantity the Bank of Canada has
created, and this surplus of money puts downward pressure
on the interest rate.
Conversely, if the interest rate is below the equilibrium level
(such as at r2), the quantity of money people want to hold is
more than the quantity the Bank of Canada has created, and
this shortage of money puts upward pressure on the interest
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rate.
 Thus, the forces of supply and demand in the market for
money push the interest rate toward the equilibrium interest
rate.
Use the Theory of Liquidity Preference to reexamine the
interest rate effect and the downward slope of Aggregate
Demand Curve
We know the price level is one determinant of the quantity
of money demanded.
A higher price level raises money demand (i.e. a shift in
the money demand curve.)
Higher money demand leads to a higher interest rate.
Higher interest rates reduces the quantity of goods and
services demanded (AD).
See Figure 20-5. 7
 As interest rates increase, the cost of borrowing and the
return to saving is greater. Fewer households and firms
borrow money, leading to a decrease in spending.
An increase in the price level causes the real exchange rate
to increase and net exports to fall.
The end result is a negative relationship between the price
level and the AD.

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Change in the money supply in a closed economy
The B of C has control over shifts in the aggregate demand
when it changes monetary policy. Recall: ( Figure 16-2)
An increase in the money supply (i.e. buying bonds)
will...shift the Money Supply to the rightwithout a change
in the Money Demand the interest rate will fall, thus
inducing people to hold the additional money the B of C has
created.
See Figure 20-6
To sum up: when the Bank of Canada 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 AD curve to the right. Conversely, when the
Bank of Canada contracts the money supply, it raises the
interest rate and reduces the quantity of goods and services
demanded for any given price level, shifting the AD curve9 to
the left.
Open-Economy Considerations
Our discussion of how monetary policy affects AD so far
has ignored open-economy considerations.
Recall in a small closed economy model:
A monetary injection by the B of C causes interest rates
to fall, leading to a stimulative effect on residential and
firm investment, and increasing output.
The increase in output requires that people hold more
money. This raises the demand curve for money and
causes a partial reversal in the interest rate.
As a result, the increase in the quantity of goods and
services is smaller that it would have otherwise been.
Now, assume Canadas interest rate should equal to the
world interest rate. ( Interest rate parity, Ch 17) 10
 See Figure 20-7, a monetary injection in an open economy
Monetary injection by the B of C causes the dollar to
depreciate, which causes net exports to rise shifting the AD
curve to the right. Output increases by more than it would in
a closed economy.
The B of C must allow the exchange rate to vary freely if its
desire is to change the money supply.
To sum up: In a small open economy, a monetary injection
by the Bank of Canada causes the dollar to depreciate in
value. Because this depreciation of the dollar causes net
exports to rise, there is an additional increase in demand for
Canadian-produced goods and services that is not realized
in a closed economy. In the end, a monetary injection in an
open economy shifts the AD curve farther to the right than it
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does in a closed economy.
 The effects of a monetary injection: Summary
See Table 20-1.

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How Fiscal Policy Influences AD
The federal government can influence the behaviour of the
economy not only with monetary policy but also with fiscal
policy.
Fiscal policy refers to the federal governments choices
regarding the overall level of government purchases or
taxes.
The federal government can influence the economy because
of the size of the central government in relation to the
economy and other economic entities.
of the deliberate use of spending and taxes to manipulate
the economy toward achieving a predetermined outcome.
The federal governments control of the economy is both
direct and indirect.
Its expenditures have a direct effect on aggregate
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spending and therefore equilibrium GDP.
 Taxes and tax policy indirectly affect the aggregate
spending of consumers.
There are two macroeconomic effects from government
purchases:
The Multiplier Effect
The Crowding-Out Effect
The Multiplier Effect of Government Purchases
Each dollar spent by the government can raise the
aggregate demand for goods and services by more than a
dollar a multiplier effect.
The total impact of the quantity of goods and services
demanded can be much larger than the initial impulse
from higher government spending.
See Figure 20-8 14
 The formula for the multiplier in a closed economy is:
Multiplier = 1 (1 - MPC)
the MPC is the Marginal Propensity to Consume.
In an open economy :
Multiplier = 1 (1 MPC+MPI)
The MPI is the Marginal Propensity to Import.
See Lipsey/Regans example on page 571/572 of
Lipsey/Regan Macroeconomics 11th edition. (Publisher:
Pearson Addison Wesley)

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The Crowding-Out Effect
An increase in government purchases causes the interest rate
to rise, and a higher interest rate tends to choke off the
demand for goods and services.
The reduction in demand that results when a fiscal
expansion raises the interest rate is called the crowding-out
effect.
See Figure 20-9
To sum up:
When the government increases its purchases by $ 5 billion,
the AD for goods and services could raise by more or less
than $5 billion, depending on whether the multiplier effect
or the crowding-out effect on investment is larger.
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A Fiscal expansion in an open economy
In a closed economy, an increase in G causes the interest
rate to rise and output to increase.
In a small, open economy, the fact that the domestic interest
rate, r2 is greater than the world interest rate, rw, means
there must be further adjustment. Canadian and foreign
savers find the Canadian interest rate more attractive than
the world interest rate. As a result, they buy Canadian assets
and sell foreign assets. The Canadian dollars appreciate.
See Figure 20-10. Fiscal expansion in an open economy
With flexible exchange rate
Crowding-out effect on net exports: the offset in AD that
results when expansionary fiscal policy in a small open
economy with a flexible exchange rate raises the real
exchange rate and thereby reduces net exports.
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 To sum up: In a small, open economy, an expansionary
fiscal policy causes the dollar to appreciate. Since this
causes net exports to fall, there is an additional crowding-
out effect that reduces the demand for Canadian produced
goods and services. In the end, fiscal policy has no lasting
effect on AD.
See Figure 20-11. Fiscal expansion in an open economy
With fixed exchange rate
To sum up: If the B of C chooses to prevent any change in
the exchange rate, an expansionary fiscal policy will have
no crowding-out effect and will therefore cause a very large
increase in the demand for goods and services.
The coordination of Monetary and Fiscal Policy
For fiscal policy to have a lasting effect on the position of
the AD curve, the Bank of Canada must choose the
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appropriate exchange rate policy.
 However, fiscal policy decisions are made by Parliament
and by provincial legislatures while monetary policy is
determined by the Bank of Canada.
Such coordination has not always been observed. (Read by
yourself)
See Table 20-2. The effects of Fiscal Policy: Summary
Changes in Taxes
When the government cuts taxes, it:
Increases households take-home pay, which ...results in
households saving some of the additional income, but
households will spend some on consumer goods, thus
shifting the aggregate-demand curve to the right.
The size of the shift in aggregate demand resulting from a
tax change is also affected by the multiplier and crowding-
out effects. 19
 The duration of the shift in the aggregate demand is also
determined by the B of Cs policy for the exchange rate
(fixed or varied).
Deficit Reduction
Canadian governments at both the federal and the
provincial levels have taken steps to reduce or eliminate
their budget deficits. Some governments have relied
primarily on reductions in expenditures, others have relied
primarily on tax increases, and others have relied on a
combination of both approaches.
As long as the B of C chooses to allow the exchange rate to
vary freely, there is no reason to expect that efforts at deficit
reduction will have any lasting influence on the position of
the AD curve.
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Using Policy to Stabilize the Economy
1, The case for active stabilization policy
If monetary and fiscal policy can be used to stabilize the
economy, then surely these tools should be used to offset the
harmful effects of economic fluctuations.
John Keynes in his book, the general theory of
employment,Interest and Money, emphasized the key role of
AD in explaining short-run economic fluctuations. Keynes
claimed that the government should actively stimulate AD
when AD appeared insufficient to maintain production at its
full-employment level.
Keynes( and his many followers) was a strong advocate of
using policy instruments to stabilize the economy.
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2, The case against active stabilization policy
The primary argument against active monetary and fiscal
policy is that these policies affect the economy with a
substantial lag. Most economists believe that it takes at least
six months for changes in monetary policy to have much
effect on output and employment.
Critics of stabilization policy argue that because of this lag,
the B of C should not try to fine-tune the economy. They
claim that the B of C often reacts too late to changing
economic conditions and as a result, ends up being a cause
of rather than a cure for economic fluctuations.

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3, All economists-both advocates and critics of stabilization
policy-agree that the lags in implementation render policy
less useful as a tool for short-run stabilization.
Automatic Stabilizers are changes in fiscal policy that
stimulate aggregate demand when the economy goes into a
recession without policy-makers having to take any
deliberate action.
Automatic stabilizers include:
The Tax System: the most important one; Ex: The
automatic tax cut in a recession stimulates AD and
thereby, reduces the magnitude of economic fluctuations.
Government Spending
Flexible Exchange Rate
However, when the economy goes into a recession, taxes
fall, government spending rises, and the governments
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budget moves toward deficit.
 If the government faced a strict balanced-budget rule, it
would be forced to look for ways to raise taxes or cut
spending in a recession. In other words, a strict balanced-
budget rule would eliminate the automatic stabilizers
inherent in our current system of taxes and government
spending.

A flexible exchange rate as an automatic stabilizer

Suppose Canadas largest trading partner, USA, slips into
recession.
As the incomes of American households and firms fall, they
spend less and we can expect that they buy fewer Canadian-
produced goods.
Canadas net exports fall and the AD shifts to the left. 24
 If the B of C has chosen to allow the exchange rate to be
flexible, we could expect the following to occur:
The fall in net exports causes the incomes of Canadians to
fall, and this reduces the demand of money. This causes
Canadas interest rate to fall below the world interest rate.
Both Canadians and foreigners sell Canadian assets in
favour of foreign assets that pay the higher world interest
rate.
The switch from Canadian to foreign assets requires a
corresponding sale of dollars in the market for foreign-
currency exchange.
The increased supply of Canadian dollars in the market
causes the exchange rate to depreciate, and this causes net
exports to increase.
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 Canadas AD shifts back to the right, increasing the incomes
of Canadians and increasing the demand for money until
Canadas interest rate is again equal to the world interest
rate.
The recession in the USA has no lasting effects on the
position of Canadas AD curve.

The effects of expansionary monetary and fiscal policies on

the AD curve (See Figure 20-12)
How fiscal and monetary policy affect the position of the
AD curve depends on whether the economy is closed or
open.
If the economy is open, the effect of fiscal and monetary
policy depends on whether the B of C chooses to fix the
value of exchange rate or allow it to be flexible.
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Conclusion
Government macroeconomic policy should proceed
carefully and with an understanding of the consequences of
its policies in the short and long-run.
Fiscal policies can have long-run effects on saving,
investment, the trade balance and growth.
Monetary policy can ultimately determine the level of prices
and affect the inflation rate.

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