THE INFLUENCE OF

34 MONETARY AND FISCAL

POLICY ON AGGREGATE
DEMAND
Questions for Review

1. The theory of liquidity preference is Keynes's theory of how the interest rate is determined.
According to the theory, the aggregate-demand curve slopes downward because: (1) a
higher price level raises money demand; (2) higher money demand leads to a higher interest
rate; and (3) a higher interest rate reduces the quantity of goods and services demanded.
Thus, the price level has a negative relationship with the quantity of goods and services
demanded.

2. A decrease in the money supply shifts the money-supply curve to the left. The equilibrium
interest rate will rise. The higher interest rate reduces consumption and investment, so
aggregate demand falls. Thus, the aggregate-demand curve shifts to the left.

3. If the government spends $3 billion to buy police cars, aggregate demand might increase by
more than $3 billion because of the multiplier effect on aggregate demand. Aggregate
demand might increase by less than $3 billion because of the crowding-out effect on
aggregate demand.

4. If pessimism sweeps the country, households reduce consumption spending and firms reduce
investment, so aggregate demand falls. If the Fed wants to stabilize aggregate demand, it
must increase the money supply, reducing the interest rate, which will induce households to
save less and spend more and will encourage firms to invest more, both of which will
increase aggregate demand. If the Fed does not increase the money supply, Congress could
increase government purchases or reduce taxes to increase aggregate demand.

5. Government policies that act as automatic stabilizers include the tax system and government
spending through the unemployment-benefit system. The tax system acts as an automatic
stabilizer because when incomes are high, people pay more in taxes, so they cannot spend
as much. When incomes are low, so are taxes; thus, people can spend more. The result is
that spending is partly stabilized. Government spending through the unemployment-benefit
system acts as an automatic stabilizer because in recessions the government transfers money
to the unemployed so their incomes do not fall as much and thus their spending will not fall
as much.

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618 v Chapter 34/The Influence of Monetary and Fiscal Policy on Aggregate Demand
Problems and Applications

1. a. When more ATMs are available, money demand is reduced and the money-demand curve
shifts to the left from MD 1 to MD 2, as shown in Figure 6. If the Fed does not change the
money supply, which is at MS1, the interest rate will decline from r1 to r2. The decline in
the interest rate shifts the aggregate-demand curve to the right, as consumption and
investment increase.

b. If the Fed wants to stabilize aggregate demand, it should reduce the money supply to MS
2, so the interest rate will remain at r1 and aggregate demand will not change.

2. a. When the Fed’s bond traders buy bonds in open-market operations, the money-supply
curve shifts to the right from MS 1 to MS 2, as shown in Figure 1. The result is a decline in
the interest rate.

Figure 1

Figure 2

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 Chapter 34/The Influence of Monetary and Fiscal Policy on Aggregate Demand v 619

b. When an increase in credit card availability reduces the cash people hold, the money-
demand curve shifts to the left from MD 1 to MD 2, as shown in Figure 2. The result is a
decline in the interest rate.

c. When the Federal Reserve reduces reserve requirements, the money supply increases, so
the money-supply curve shifts to the right from MS 1 to MS 2, as shown in Figure 1. The
result is a decline in the interest rate.
d. When households decide to hold more money to use for holiday shopping, the money-
demand curve shifts to the right from MD 1 to MD 2, as shown in Figure 3. The result is a
rise in the interest rate.

Figure 3

e. When a wave of optimism boosts business investment and expands aggregate demand,
money demand increases from MD 1 to MD 2 in Figure 3. The increase in money demand
increases the interest rate.

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620 v Chapter 34/The Influence of Monetary and Fiscal Policy on Aggregate Demand
Figure 4

3. a. The increase in the money supply will cause the equilibrium interest rate to decline, as
shown in Figure 4. Households will increase spending and will invest in more new
housing. Firms too will increase investment spending. This will cause the aggregate
demand curve to shift to the right as shown in Figure 5.

Figure 5

b. As shown in Figure 5, the increase in aggregate demand will cause an increase in both
output and the price level in the short run.

c. When the economy makes the transition from its short-run equilibrium to its long-run
equilibrium, short-run aggregate supply will decline, causing the price level to rise even
further.

d. The increase in the price level will cause an increase in the demand for money, raising
the equilibrium interest rate.

e. Yes. While output initially rises because of the increase in aggregate demand, it will fall
once short-run aggregate supply declines. Thus, there is no long-run effect of the
increase in the money supply on real output.

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 Chapter 34/The Influence of Monetary and Fiscal Policy on Aggregate Demand v 621

Figure 6

4. A tax cut that is permanent will have a bigger impact on consumer spending and aggregate
demand. If the tax cut is permanent, consumers will view it as adding substantially to their
financial resources, and they will increase their spending substantially. If the tax cut is
temporary, consumers will view it as adding just a little to their financial resources, so they
will not increase spending as much.

5. a. The current situation is shown in Figure 7.

Figure 7

b. The Fed will want to stimulate aggregate demand. Thus, it will need to lower the interest
rate by increasing the money supply. This could be achieved if the Fed purchases
government bonds from the public.

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622 v Chapter 34/The Influence of Monetary and Fiscal Policy on Aggregate Demand

Figure 8

c. As shown in Figure 8, the Fed's purchase of government bonds shifts the supply of
money to the right, lowering the interest rate.

d. The Fed's purchase of government bonds will increase aggregate demand as consumers
and firms respond to lower interest rates. Output and the price level will rise as shown in
Figure 9.

Figure 9

6. a. Legislation allowing banks to pay interest on checking deposits increases the return to
money relative to other financial assets, thus increasing money demand.

b. If the money supply remained constant (at MS1), the increase in the demand for money
would have raised the interest rate, as shown in Figure 10. The rise in the interest rate
would have reduced consumption and investment, thus reducing aggregate demand and
output.

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 Chapter 34/The Influence of Monetary and Fiscal Policy on Aggregate Demand v 623

c. To maintain a constant interest rate, the Fed would need to increase the money supply
from MS 1 to MS 2. Then aggregate demand and output would be unaffected.

Figure 10

7. a. If there is no crowding out, then the multiplier equals 1/(1 – MPC ). Because the
multiplier is 3, then MPC = 2/3.

b. If there is crowding out, then the MPC would be larger than 2/3. An MPC that is larger
than 2/3 would lead to a larger multiplier than 3, which is then reduced down to 3 by the
crowding-out effect.

8. a. The initial effect of the tax reduction of $20 billion is to increase aggregate demand by
$20 billion x 3/4 (the MPC ) = $15 billion.

b. Additional effects follow this initial effect as the added incomes are spent. The second
round leads to increased consumption spending of $15 billion x 3/4 = $11.25 billion. The
third round gives an increase in consumption of $11.25 billion x 3/4 = $8.44 billion. The
effects continue indefinitely. Adding them all up gives a total effect that depends on the
multiplier. With an MPC of 3/4, the multiplier is 1/(1 – 3/4) = 4. So the total effect is $15
billion x 4 = $60 billion.

c. Government purchases have an initial effect of the full $20 billion, because they increase
aggregate demand directly by that amount. The total effect of an increase in government
purchases is thus $20 billion x 4 = $80 billion. So government purchases lead to a bigger
effect on output than a tax cut does. The difference arises because government
purchases affect aggregate demand by the full amount, but a tax cut is partly saved by
consumers, and therefore does not lead to as much of an increase in aggregate demand.

d. The government could increase taxes by the same amount it increases its purchases.

9. a. If the marginal propensity to consume is 0.8, the spending multiplier will be 1/(1-0.8) =
5. Therefore, the government would have to increase spending by $400/5 = $80 billion
to close the recessionary gap.

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624 v Chapter 34/The Influence of Monetary and Fiscal Policy on Aggregate Demand

b. With an MPC of 0.8, the tax multiplier is (0.8)(1/(1-0.8)) = (0.8)(5) = 4. Therefore, the
government would need to cut taxes by $400 billion/4 = $100 billion to close the
recessionary gap.

c. If the central bank was to hold the money supply constant, my answer would be larger
because crowding out would occur.

d. They would have to raise both government spending and taxes by $400 billion. The
increase in government purchases would result in a boost of $2,000 billion, while the
higher taxes would reduce spending by $1,600 billion. This leaves a $400 billion rise in
aggregate spending.

10. If government spending increases, aggregate demand rises, so money demand rises. The
increase in money demand leads to a rise in the interest rate and thus a decline in aggregate
demand if the Fed does not respond. But if the Fed maintains a fixed interest rate, it will
increase money supply, so aggregate demand will not decline. Thus, the effect on aggregate
demand from an increase in government spending will be larger if the Fed maintains a fixed
interest rate.

11. a. Expansionary fiscal policy is more likely to lead to a short-run increase in investment if
the investment accelerator is large. A large investment accelerator means that the
increase in output caused by expansionary fiscal policy will induce a large increase in
investment. Without a large accelerator, investment might decline because the increase
in aggregate demand will raise the interest rate.

b. Expansionary fiscal policy is more likely to lead to a short-run increase in investment if

the interest sensitivity of investment is small. Because fiscal policy increases aggregate
demand, thus increasing money demand and the interest rate, the greater the sensitivity
of investment to the interest rate the greater the decline in investment will be, which will
offset the positive accelerator effect.

12. a. Tax revenue declines when the economy goes into a recession because taxes are closely
related to economic activity. In a recession, people's incomes and wages fall, as do firms'
profits, so taxes on these things decline.

b. Government spending rises when the economy goes into a recession because more
people get unemployment-insurance benefits, welfare benefits, and other forms of
income support.

c. If the government were to operate under a strict balanced-budget rule, it would have to
raise tax rates or cut government spending in a recession. Both would reduce aggregate
demand, making the recession more severe.

13. a. If there were a contraction in aggregate demand, the Fed would need to increase the
money supply to increase aggregate demand and stabilize the price level, as shown in
Figure 11. By increasing the money supply, the Fed is able to shift the aggregate-
demand curve back to AD 1 from AD 2. This policy stabilizes output and the price level.

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 Chapter 34/The Influence of Monetary and Fiscal Policy on Aggregate Demand v 625

Figure 11

b. If there were an adverse shift in short-run aggregate supply, the Fed would need to
decrease the money supply to stabilize the price level, shifting the aggregate-demand
curve to the left from AD 1 to AD 2, as shown in Figure 12. This worsens the recession
caused by the shift in aggregate supply. To stabilize output, the Fed would need to
increase the money supply, shifting the aggregate-demand curve from AD 1 to AD 3.
However, this action would raise the price level.

Figure 12

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