23115 Lecture Notes - Lecture 11: Xm Satellite Radio, Automatic Stabilizer, Monetary Policy
Lecture 11 - Monetary Policy and Fiscal Policy
THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE
DEMAND (CHAPTER 32)
• In this chapter, we will examine how the goerets tools of monetary and fiscal policy affect
aggregate demand (AD) and short‐ru ecooic fluctuatios. We will discuss:
• ‐ Monetary policy and aggregate demand (AD). Central Bank
• ‐ Fiscal policy and aggregate demand (AD). Government.
HOW MONETARY POLICY INFLUENCES AGGREGATE DEMAND
• The AD aggregate‐dead cure shows the quantity of goods and services demanded for any
inflation rate. It is downward sloping.
The wealth effect – A loe pie leel aises the eal alue of households oe holdigs, ad
higher real wealth stimulates consumer spending.
The interest rate effect – A lower price level lowers the interest rate as people try to lend out their
excess money holdings, and lower interest rate stimulates investment spending. The exchange rate
effect [not important if closed economy] – When a lower price level lowers interest rate, investors
move some of their funds overseas and cause the domestic currency to depreciate relative to
foreign currencies. This depreciation makes domestic goods cheaper compared to foreign goods
and, therefore, stimulates spending on NX.
❖ The INTEREST RATE EFFECT is the most important in explaining the downward slope. ▪ The
downward slope of the AD curve.
o A higher inflation rate induces the RBA to increase interest rates.
This is i aodae ith the ‘BAs poli guidelies.
▪ A higher interest rate reduces the quantity of goods and services demanded.
‐ A higher interest rate higher cost of borrowing and higher return on saving less
(residential and business) investment; less consumption by households and more saving aggregate
demand falls.
Changes in the cash rate move us up and down the AD curve.
• ‐ A reduction in the cash rate induced by a reduction in the inflation rate (a loosening
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monetary policy), leads to an increase in the quantity of goods and services demanded.
• ‐ An increase in the cash rate induced by an increase in the inflation rate (a tightening
monetary policy), reduces the quantity of goods and services demanded.
THE THEORY OF LIQUIDITY PREFERENCE
• Theory of liquidity preference is Keess theo that the iteest ate adjusts to ig oe
supply and money demand into balance.
▪ Recall that REAL INTEREST RATE = NOMINAL INTEREST RATE – INFLATION.
• ‐ In the short run, we hold constant the expected rate of inflation. Nominal and real interest
rates differ by a constant.
• ‐ For the rest of this chapter, when we refer to changes in the interest rate, we assume the
real and nominal interest rate move in the same direction. MONEY SUPPLY
▪ We assume that the central bank controls the money supply directly the quantity of money
supplied does not depend on other economic variables, including the interest rate. This means the
money supply curve is vertical at the fixed quantity.
MONEY DEMAND
▪ A assets liquidity efes to the ease ith hih that asset is oeted ito the eoos
medium of exchange.
o Moe is the eoos ediu of ehage, so it is the ost liuid asset aailale.
• ▪ The liquidity of money explains the demand for money – people choose to hold money
istead of othe assets eause oe a e used to u iteest‐eaig fiaial assets
as well as goods and services.
• ▪ One important variable that determines the demand for money is the interest rate. The
opportunity cost of holdig oe is the highest iteest that ould e eaed o iteest‐
earning assets. A higher interest rate leads to a lower demand for money.
An increase in the interest rate raises the cost of holding money the quantity of money
demanded decreases the money demand curve is downward sloping.
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•
EQUILIBRIUM IN THE MONEY MARKET
• According to 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 balances the quantity of money supplied.
• ➢ If the interest rate is at any other level, people will try to adjust their portfolios of
assets
through buy and selling and, as a result, drive the interest rate toward the equilibrium
1. BONDS
▪ ▪
So something else has to change to make the yield on the bond the same as the market rate
of interest. This is the price of the bond, PB.
Simple formula for a bond with an infinite maturity: PB = C/r.
Inverse relationship between PB and r, since C is fixed.
EQUILIBRIUM IN THE MONEY MARKET (CONTINUED)
• In the figure below, the money supply curve is MS* and the equilibrium interest rate is .
o ‐ If the interest rate is above demand for money is excess supply of money
people t to get id of oe uig iteest‐eaig assets highe dead fo
iteest‐eaig assets ieases PB ad loes the iteest ate to .
o ‐ If the interest rate is below demand for money is excess demand for money
people try to get more money by selling their bonds lower demand for bonds lowers
PB ad hee ieases the iteest ate to .
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Document Summary
Lecture 11 - monetary policy and fiscal policy. The influence of monetary and fiscal policy on aggregate. Demand (chapter 32: in this chapter, we will examine how the go(cid:448)er(cid:374)(cid:373)e(cid:374)t(cid:859)s tools of monetary and fiscal policy affect aggregate demand (ad) and short ru(cid:374) eco(cid:374)o(cid:373)ic fluctuatio(cid:374)s. we will discuss: How monetary policy influences aggregate demand: the ad (cid:894)aggregate de(cid:373)a(cid:374)d(cid:895) cur(cid:448)e shows the quantity of goods and services demanded for any inflation rate. The wealth effect a lo(cid:449)e(cid:396) p(cid:396)i(cid:272)e le(cid:448)el (cid:396)aises the (cid:396)eal (cid:448)alue of households(cid:859) (cid:373)o(cid:374)e(cid:455) holdi(cid:374)gs, a(cid:374)d higher real wealth stimulates consumer spending. The interest rate effect a lower price level lowers the interest rate as people try to lend out their excess money holdings, and lower interest rate stimulates investment spending. The exchange rate effect [not important if closed economy] when a lower price level lowers interest rate, investors move some of their funds overseas and cause the domestic currency to depreciate relative to foreign currencies.
