Mind Map Gallery Monetary and Fiscal Policy's Impact on Aggregate Demand
This mind map provides an in-depth examination of how monetary and fiscal policy tools influence aggregate demand within an economy. It details specific economic theories and models, and illustrates the cause-and-effect relationships between policy decisions and economic outcomes.Edited at 2022-11-05 13:35:53
The influence of Monetary and Fiscal Polocy on Aggregate Demand
How Monetary Policy influences Aggregate Demand
The theory of Liquidity Preference
Money Supply controlled by the Federal Reserve.
The Fed can alter the supply of money
using open market operations
changes in the discount rate
changes in reserve requirements
Money supply is vertical: quantity supplied is independent of any other economic variable, including interest rates
money is the most liquid asset in the economy.
The liquidity of money explains why people choose to hold it instead of other assets that could earn them a higher return.
the demand curve slopes down :interest rate rises, the quantity of money demanded will fall
Equilibrium in the Money Market
The interest rate adjusts to bring money demand and money supply into balance
If the interest rate is higher than the equilibrium interest rate, the quantity of money that people want to hold is less than the quantity that the Fed has supplied. Thus, people will try to buy bonds or deposit funds in an interest-bearing account. This increases the funds available for lending, pushing interest rates down
. If the interest rate is lower than the equilibrium interest rate, the quantity of money that people want to hold is greater than the quantity that the Fed has supplied. Thus, people will try to sell bonds or withdraw funds from an interest-bearing account. This decreases the funds available for lending, pulling interest rates up.
The Downward Slope of the Aggregate Demand Curve
Increase in the price level -> increase in the demand ->shifting the money demand curve to the right
The interest rate increase ->firm to borrow money for new equipment or structures increase ->In short,quantity of goods and services purchased decrease
Price level increases, the quantity of goods and services demanded falls -> This is Keynes’s interest-rate effect.
Changes in the Money Supply
increase money supply -> real interest rate decrease-> investment increase-> shifting the aggregate demand curve to the right( in short)
Fediral Fundstare: When Federal Fundsrate increase -> reserved increase-> loans decrease-> money supply decrease-> control money supply.
The role of Interest rate Targets in Fed Policy
The Fed has conducted policy by setting a target for the Federal funds rate
The target is reevaluated every six weeks when the Federal Open Market Committee meets.
The Fed has chosen to use this interest rate as a target in part because the money supply is difficult to measure with sufficient precision.
Because changes in the money supply lead to changes in interest rates, monetary policy can be described either in terms of the money supply or in terms of the interest rate
How Fiscal Policy influences Aggregate Demand
The setting of the level of government spending and taxation by government policymakers.
Changes in Government Purchases
An increase in government purchases shifts the aggregate-demand curve to the right, while a decrease in government purchases shifts the aggregate-demand curve to the left
The Multiplier Effect : the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending
When consumers spend part of their additional income, it provides additional income for other consumers
These consumers then spend some of this additional income, raising the incomes of yet another group of consumers.
Multiplier = 1/(1-MPC)
The Crowding – out Effect: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending
When the government purchases a product from a company A, the immediate effect of the purchase is to increase profits and employment at that company. As a result, the owners and workers at this company will see an increase in income, and therefore will be able to increase their consumption. If consumers want to buy more goods and services, they will need to increase their money holdings. This shifts the demand for money to the right, increase interest rates
in crease interest rate ->decrease in investment -> So, although an increase in government purchases shifts the aggregate demand curve to the right, this decrease in consumption and investment will make the aggregate demand curve shift to the left. Therefore, aggregate demand increases less than government purchases increase
when the government increases its purchases by $X, the aggregate demand for goods and services could rise by more or less than $X, depending on the sizes of the multiplier and crowding-out effects.
If the multiplier effect is greater than the crowding-out effect, aggregate demand will rise by more than $X.
If the multiplier effect is less than the crowding-out effect, aggregate demand will rise by less than $X.
Changes in Taxes
Government cuts Personal Income Tax -> Changes in taxes affect a household’s take-home pay.
The goverment reduce taxes -> aggregate-demand curve to the right.
The goverment raise taxes -> aggregate-demand curve to the left
Cut personal Income taxes -> income increase -> speding increase-> income of another increase -> Multiplier effect
When speding increase -> money demand increase -> interest rate increase-> invesment decrease-> Aggregate demand decrease( but only pemanent)
Using Policy to stabilize the Economy
The case for Active Stabilization Policy
Some economists believe that fiscal and monetary policy tools should only be used to help the economy achieve long-run goals, such as low inflation and rapid economic growth.
The primary argument against active policy is that these policy tools may affect the economy with a long lag
With monetary policy, the change in money supply leads to a change in interest rates. This change in interest rates affects investment spending. However, investment decisions are usually made well in advance, so the effects from changes in investment will not likely be felt in the economy very quickly
The lag in fiscal policy is generally due to the political process. Changes in spending and taxes must be approved by both the House and the Senate (after going through committees in both houses).
By the time these policies take effect, the condition of the economy may have changed. This could lead to even larger problems
Automatic stabilizers: changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession but that occur without policymakers having to take any deliberate action.
The most important automatic stabilizer is the tax system
Some government spending is also an automatic stabilizer.