Implications for Aggregate Demand for Goods and Services

The Downward Slope of the Aggregate-Demand Curve

Having seen how the theory of liquidity preference Opens in new window explains the economy’s equilibrium interest rate, we now consider the theory’s implications for the aggregate-demand for goods and services.

As a warm-up exercise, let’s begin by using the theory to reexamine the interest-rate effect and the downward slope of the aggregate-demand curve Opens in new window.

In particular, suppose that the overall level of prices in the economy rises. What happens to the interest rate that balances the supply and demand for money, and how does that change affect the quantity of goods and services demanded?

The price level is one determinant of the quantity of money demanded. At higher prices, more money is exchanged every time a good or service is sold. As a result, people will choose to hold a larger quantity of money.

That is, a higher price level increases the quantity of money demanded for any given interest rate. Thus, an increase in the price level from P1 to P2 shifts the money demanded curve to the right from MD1 to MD2, as shown in panel (a) of Figure II.

The-Money-Market-and-the-Slope-of-the-Aggregate-Demand-Curve Figure II, The Money Market and the Slope of the Aggregate-Demand Curve | Source: Slideplayer Opens in new window
An increase in the price level from P1 to P2 shifts the money demand curve to the right, as in panel (a). This increase in money demand causes the interest rate to rise from r1 to r2. Because the interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods and services demanded from Y1 to Y2. This negative relationship between the price level and quantity demanded is represented with a downward-sloping aggregate-demand curve, as in panel (b).
Notice how this shift in money demand affects the equilibrium in the money market.

For a fixed money supply, the interest rate must rise to balance money supply and money demand.

Because the higher price level has increased the amount of money people want to hold, it has shifted the money demand curve to the right. Yet the quantity of money supplied is unchanged, so the interest rate must rise from r1, to r2 to discourage the additional demand.

This increase in the interest rate has ramifications not only for the money market but also for the quantity of goods and services demanded, as shown in panel (b).

At a higher interest rate, the cost of borrowing and the return to saving are greater.
  • Fewer households choose to borrow to buy a new house, and those who do buy smaller houses, so the demand for residential investment falls.
  • Fewer firms choose to borrow to build new factories and buy new equipment, so business investment falls.

Thus, when the price level rises from P1 to P2, increasing money demand from MD1 to MDs and raising the interest rate from r1 to r2, the quantity of goods and services demanded falls from Y1 to Y2.

This analysis of the interest-rate effect can be summarized in three steps:

  1. A higher price level raises money demand.
  2. Higher money demand leads to a higher interest rate.
  3. A higher interest rate reduces the quantity of goods and services demanded.
The logic works for a decline in the price level:

A lower price level reduces money demand, which leads to a lower interest rate, and this in turn increases the quantity of goods and services demanded.

The result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded, as illustrated by a downward-sloping aggregate-demand curve.

Changes in the Money Supply

So far, we have used the theory of liquidity preference to explain more fully how the total quantity of goods and services demanded in the economy changes as the price level changes. That is, we have examined movements along a downward-sloping aggregate-demand curve.

The theory also sheds light, however, on some of the other events that alter the quantity of goods and services demanded.

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 Opens in new window is monetary policy Opens in new window. To see how monetary policy affects the economy in the short-run, suppose that the Fed increases the money supply by buying government bonds in open-market operations. (Why the Fed might do this will become clear later, after we understand the effects of such a move.)

Let’s consider how this monetary injection influences the equilibrium interest rate for a given price level.

This will tell us what the injection does to the position of the aggregate-demand curve.

The-Money-Market-and-the-Slope-of-the-Aggregate-Demand-Curve Figure III, The Effect of a Monetary Injection | Source: Slideplayer Opens in new window
In panel (a), an increase in the money supply from MS1 to MS2 reduces the equilibrium interest rate from r1 to r2. Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of goods and services demanded at a given price level from Y1 to Y2. Thus, in panel (b), the aggregate-demand curve shifts to the right from AD1 to AD2.

As panel (a) of Figure III shows, an increase in the money supply shifts the money supply curve to the right from MS1 to MS2.

Because the money demand curve has not changed, the interest rate falls from r1 to r2 to balance money supply and money demand. That is, the interest rate must fall to induce people to hold the additional money the Fed has created, restoring equilibrium in the money market.

Once again, the interest rate influences the quantity of goods and services demanded, as shown in panel (b) of Figure III.

The lower interest rate reduces the cost of borrowing and the return to saving.
  • Households spend more on new homes, stimulating the demand for residential investment.
  • Firms spend more on new factories and new equipment, stimulating business investment.

As a result, the quantity of goods and services demanded at a given price level, P, rises from Y1 to Y2. Of course, there is nothing special about P: The monetary injection raises the quantity of goods and services demanded at every price level. Thus, the entire aggregate-demand curve shifts to the right.

To sum up: When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the right. Conversely, when the Fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the right.

The Role of Interest-Rate Targets in Fed Policy

How does the Federal Reserve Opens in new window affect the economy? Our discussion here and earlier Opens in new window in the literature has treated the money supply as the Fed’s policy instrument.

  • When the Fed buys government bonds in open-market operations, it increases the money supply and expands aggregate demand.
  • When the Fed sells government bonds in open-market operations, it decreases the money supply and contracts aggregate demand.
Focusing on the money supply is a good starting point, but another perspective is useful when thinking about recent policy.

In the past, the Fed has at times set a target for the money supply, but that is no longer the case.

The Fed now conducts policy by setting a target for the federal funds rate—the interest rate that banks charge one another for short-term loans. This target is reevaluated every six weeks at meetings of the Federal Open Market Committee (FOMC) Opens in new window.

There are several related reasons for the Fed’s decision to use the federal funds rate as its target.
  • One is that the money supply is hard to measure with sufficient precision.
  • Another is that money demand fluctuates over time.

For any given money supply, fluctuations in money demand lead to fluctuations in interest rates, aggregate demand, and output. By contrast, when the Fed announces a target for the federal funds rate Opens in new window, it essentially accommodates the day-to-day shifts in money demand by adjusting the money supply accordingly.

The Fed’s decision to target an interest rate does not fundamentally alter our analysis of monetary policy. The theory of liquidity preference illustrates an important principle:

Monetary policy Opens in new window can be described either in terms of the money supply or in terms of the interest rate.

When the FOMC sets a target for the federal funds rate of, say, 4 percent, the Fed’s bond traders are told: “Conduct whatever open-market operations are necessary to ensure that the equilibrium interest rate is 4 percent.”

In other words, when the Fed sets a target for the interest rate, it commits itself to adjusting the money supply to make the equilibrium in the money market hit that target.

As a result, changes in monetary policy can be viewed either in terms of changing the interest rate target or in terms of changing the money supply.

When you read in the news that “the Fed has lowered the federal funds rate from 4 to 3 percent,” you should understand that this occurs only because the Fed’s bond traders are doing what it takes to make sure that the interest rate changes.

To lower the federal funds rate, the Fed’s bond traders buy government bonds, and this purchase increases the money supply and lowers the equilibrium interest rate (just as in Figure III). Conversely, when the FOMC raises the target for the federal funds rate, the bond traders sell government bonds, and this sale decreases the money supply and raises the equilibrium interest rate.

The lessons from this analysis are simple:
  • Changes in monetary policy aimed at expanding aggregate demand can be described either as increasing the money supply or as lowering the interest rate.
  • Changes in monetary policy aimed at contracting aggregate demand can be described either as decreasing the money supply or as raising the interest rate.

The Zero Lower Bound

As we have just seen, monetary policy works through interest rates. This conclusion raises a question: What if the Fed’s target interest rate has fallen as far as it can? In the Great Recession of 2008 and 2009 Opens in new window, the federal funds rate fell to about zero. In this situation, what, if anything, can monetary policy do to stimulate the economy?

Some economists describe this situation as a liquidity trap Opens in new window. According to the theory of liquidity preference, expansionary policy works by reducing interest rates and stimulating investment spending. But if interest rates have already fallen to around zero, monetary policy may no longer be effective.

Nominal interest rates cannot fall much below zero: Rather than making a loan at a negative nominal interest, a person would just hold cash. In this environment, expansionary monetary policy raises the supply of money, making the public’s asset portfolio more liquid, but because interest rate can’t fall any further, the extra liquidity might not have any effect. Aggregate demand, production, and employment may be “trapped” at low levels.

Other economists are skeptical about the relevance of liquidity traps and believe that a central bank continues to have tools to expand the economy, even after its interest rate target hits its lower bound of zero.

One option is to have the central bank commit itself to keeping interest rates low for an extended period of time.

Such a policy is sometimes called forward guidance Opens in new window. Even if the central bank’s current target for the interest rate cannot fall any further, the promise that interest rates will remain low may help stimulate investment spending.

A second option is to have the central bank conduct expansionary open-market operations using a larger variety of financial instruments.

Normally, the Fed conducts expansionary open-market operations by buying short-term government bonds. But it could also buy mortgage-backed securities and longer-term government bonds to lower the interest rates on these kinds of loans.

This type of unconventional monetary policy is sometimes called quantitative easing Opens in new window because it increases the quantity of bank reserves. During the Great Recession Opens in new window, the Fed engaged in both forward guidance and quantitative easing.

Some economists have suggested that the possibility of hitting the zero lower bound for interest rates justifies setting the target rate of inflation well above zero. Under zero inflation, the real interest rate, like the nominal interest rate, can never fall below zero.

But if the normal rate of inflation is, say, 4 percent by lowering the nominal interest rate to zero. Thus, a higher inflation target gives monetary policymakers more room to stimulate the economy when needed, reducing the risk of hitting the zero lower bound and having the economy fall into a liquidity trap.