Lecture 11

The Influence of Monetary & Fiscal Policy on

Aggregate Demand (Part 1)
(Ch:21; P.O.M.E)

ECO 104
Faculty: Asif Chowdhury

How Monetary Policy influences

Aggregate Demand (AD):
Previously we have seen that the three theories
have been put forward to explain the downward
slope of the Aggregate Demand curve (AD) are:
The Wealth Effect
The Interest Rate Effect
The Exchange Rate Effect
The wealth effect doesnt have a substantial
impact on the AD. Also, in a developed
countries like US, import & export comprise a
small share of GDP, so this too doesnt have a
substantial impact on AD. That leaves out the
interest rate effect, which is most important in
explaining the downward slope of the AD curve.

Theory of Liquidity
Preference:
Seeing previously that how prominent the
interest rate effect is on the Aggregate
Demand, focus is now on rate of interest &
how its determined in the short run. To
achieve this end, Theory of Liquidity
Preference is used to explain how interest
rate is determined in the short run
Theory of Liquidity Preference: Keynes
theory that interest rate adjust to bring
money supply & money demand into
equilibrium.

 Through
this
theory
a
linked
approach, as to why AD is downward
sloping, will be provide. Also, will be
explained how monetary & fiscal
policy can shift the AD curve. Tying
them up together will lead to an
analysis of short run economic
fluctuations.

Money Supply & Money

Demand:
Since interest rate is categorized into real
rate & nominal rate, for the purpose of
analyzing
the
Theory
of
Liquidity
Preference, we shall consider both of
them. Since real interest rate is nominal
interest rate adjusted for inflation, by
holding the inflation rate constant ( is
feasible in the short run phase), both the
real & nominal interest rate will move in the
same direction. So rather than classifying
interest rate into two categories, the ahead
analysis will be centered around just the
interest rate.

 Money Supply: is fixed by the Central Bank

& doesnt depend on interest rate.
Money Demand: is downward sloping
implying an inverse relationship between
interest rate & money demand. People
hold money for transaction purpose &
because of its liquidity. The opportunity
cost of holding money is the interest rate.
When interest rate is high people want to
hold less money & when interest rate is
low people want to hold more money.

Equilibrium in the money

market:
When interest rate is above the
equilibrium level, people try to
reduce their money holdings, this in
turn lowers the interest rate towards
equilibrium. When the interest rate is
below the equilibrium level, people
try to maintain higher money stock in
hand, this in turn raises the interest
rate towards the equilibrium.

Linking Aggregate Demand to

Money Market:
When the general price level rises in the
market for goods & services, then the
money demand curve shifts upward in the
money market, since people want to hold
more money as with rising price level, real
value of money falls. This in turn leads to
interest rate rise. With higher interest rate,
Investment level goes down, so there is a
corresponding reduction in the total
quantity
of
goods
&
services,
as
demonstrated by movement along the AD
curve. Thus a downward sloping AD curve is
explained.

Changing the money supply:

When the government implement monetary
policy through the Central Bank, by
changing the money supply, it has an
impact on the Aggregate Demand. Raising
the money supply will lead to interest rate
to fall, this in turn leads to higher level of
investment, since cost of borrowing fund is
now lower. With price level remaining same
in the market for goods & services, higher
investment level will shift the Aggregate
Demand to the right & vice versa.