Institute of International Education 4 2 Monetary and Fiscal Policy Monetary and Fiscal policy are used to offset shifts in AD which cause short run fluctuations in output and employment ▪ Monetary po[.]
4.2 Monetary and Fiscal Policy Monetary and Fiscal policy are used to offset shifts in AD which cause short-run fluctuations in output and employment ▪ Monetary policy: the setting of the money supply by policymakers in the central bank ▪ Fiscal policy: changes in government spending or tax rates Institute of International Education How Monetary Policy Influences AD ▪ Recall, the AD curve slopes downward for three reasons: ▪ The wealth effect ▪ The interest-rate effect ▪ The exchange-rate effect ▪ A supply-demand model that helps explain the interest-rate effect and how monetary policy affects AD Institute of International Education The Theory of Liquidity Preference The theory of liquidity preference is developed in order to explain what factors determine the economy’s interest rate (denoted r) According to the theory, the interest rate adjusts to balance the supply and demand for money Institute of International Education Money Supply ▪ The money supply is controlled by the Fed through: ❑ Open-market ▪ operations ❑ Changing the reserve requirements ❑ Changing the discount rate Thus, the quantity of money supplied does not depend on the interest rate and is vertical Institute of International Education Money Demand Money demand is determined by several factors According to the theory of liquidity preference, one of the most important factors is r A household’s “money demand” reflects its preference for liquidity • People choose to hold money because money can be used to buy other goods and services Institute of International Education Money Demand The opportunity cost of holding money is the interest that could be earned on interest-earning assets An increase in the interest rate raises the opportunity cost of holding money ➔ The quantity of money demanded is reduced Institute of International Education ACTIVE LEARNING The determinants of MD A Suppose r rises, but Y and P are unchanged What happens to money demand? B Suppose P rises, but Y and r are unchanged What happens to money demand? Institute of International Education ACTIVE LEARNING Answers A Suppose r rises, but Y and P are unchanged What happens to money demand? r is the opportunity cost of holding money An increase in r reduces money demand: households attempt to buy bonds to take advantage of the higher interest rate Hence, an increase in r causes a decrease in money demand, other things equal Institute of International Education ACTIVE LEARNING Answers B Suppose P rises, but Y and r are unchanged What happens to money demand? If Y is unchanged, people will want to buy the same amount of g&s Since P is higher, they will need more money to so Hence, an increase in P causes an increase in money demand, other things equal Institute of International Education 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 equals the quantity of money supplied Institute of International Education ... but Y and r are unchanged What happens to money demand? Institute of International Education ACTIVE LEARNING Answers A Suppose r rises, but Y and P are unchanged What happens to money demand?... exchange-rate effect ▪ A supply-demand model that helps explain the interest-rate effect and how monetary policy affects AD Institute of International Education The Theory of Liquidity Preference... quantity of money supplied does not depend on the interest rate and is vertical Institute of International Education Money Demand Money demand is determined by several factors According to the theory