1. How monetary policy influences aggregate demand?
- The aggregate demand curve shows the total quantity of goods and services
demanded in the economy for any price level.
In the short run, there is no change in price level -> the output can be determined
by the AD curve
Lower output, higher U rate
- 3 reasons the aggregate demand curve slopes downward:
+ The wealth effect: a lower price level -> raise the real value of households’
money holdings -> higher real wealth stimulates consumer spending -> increase
the quantity of goods and services demanded
+ The interest-rate effect: a lower price level reduces the amount of money people
want to hold -> people try to lend out their excess money holdings -> the interest
rate falls -> stimulate investment spending and thus increases the quantity of goods
and services demanded.
+ The exchange-rate effect: when a lower price level reduces the interest rate ->
investors moves some of their funds overseas in search of higher returns -> cause
the real value of domestic currency to fall in the market for foreign-currency
exchange (Domestic goods become less expensive than foreign goods) -> stimulate
spending on net exports and increases the quantity of goods and services
demanded.
- These 3 effects can explain the downward slope of the aggregate – demand curve
but they are not of equal importance:
+ The wealth effect is the least important (money holdings are a small part of
household wealth)
+ The exchange rate effect is less or more important (exports and imports represent
only a small fraction of a country’s GDP)
+ The interest-rate effect is the most important
2. The theory of liquidity preference:
- The theory of liquidity preference: Keynes’s theory that the interest rate adjusts
to bring money supply and money demand into balance
a) Money supply:
- controlled by the Central bank (the Federal Reserves)
- The Fed alters the money supply primarily by changing the quantity of reserves
in the banking system through the purchase and sale of government bonds in open-
market operations.
- When the Fed buys government bonds, the dollars it pays for the bonds are
typically deposited in banks, and these dollars are added to bank reserves. When
the Fed sells government bonds, the dollars it receives for the bonds are withdrawn
from the banking system, and bank reserves fall
>>> changes in the ability of making loans and creating money
- The Fed can also influence the money supply by using a variety of tools:
+ One option is for the Fed to change how much it lends to banks. (a decrease in
discount rate encourages more bank borrowing, which rises the bank reserves and
money supply)
+ The Fed alters the money supply by changing reserve requirements (the amount
of reserves banks must hold against deposits) and by changing the interest rate it
pays banks on the reserves they are holding
- The quantity of money supplied
+ fixed by monetary policy
+ doesn’t vary with interest rate
b) Money demand:
- Recall: any asset’s liquidity refers to the ease with which that asset can be
converted into the economy’s medium of exchange.
- Money is the economy’s medium of exchange in the economy -> it is defined as
the most liquid asset available.
- 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
- Variables that affect money demand: real income, interest rate and price level
- The factor emphasized to affect the quantity of money demanded is the interest
rate (because it is the opportunity cost of holding money)
- An increase in the interest rate -> raises the cost of holding money -> reduces the
quantity of money demanded (opposite for a decrease in interest rate)
c) Equilibrium in the money market
- Interest rate adjusts to balance the supply of and demand for money
- At equilibrium interest rate, quantity of money demanded exactly balances the
quantity of money supplied
* If interest rate > equilibrium:
- Quantity of money demanded < quantity of money supplied
>> surplus -> put downward pressure on the interest rate until equilibrium (holder:
buy interest-bearing bonds or deposit it in an interest-bearing bank account -> bond
issuers and banks tend to pay lower interest rates)
* If interest rate < equilibrium:
- Quantity of money demanded > quantity of money supplied
>> Shortage -> put upward pressure on the interest rate until equilibrium
3. The downward slope of the aggregate – demand curve
- This analysis of the interest-rate effect can be summarized in three steps:
+ A higher price level raises money demand
+ Higher money demand leads to a higher interest rate
+ A higher interest rate reduces the quantity of goods and services
>>> the negative relationship between the price level and the quantity of goods and
services demanded as illustrated by a downward-sloping aggregate demand curve
=> Price level rises, aggregate quantity demanded falls, other things equal and vice
versa
4. Changes in the money supply
- Whenever the quantity of goods and services demanded changes for any given
price level, the aggregate-demand curve shifts
- One important variable that shifts the aggregate-demand curve is monetary
policy.
Monetary policy
-> keep table prices and maximum sustainable unemployment
Expansionary moneytary policy: increase MS
