Monetary and Fiscal Policy

The Influence of Monetary and Fiscal Policy on Aggregate Demand

Imagine that you are a member of the Federal Open Market Committee Opens in new window, the group at the Federal Reserve that sets monetary policy. You observe that the president and Congress have agreed to raise taxes.

To answer this question, you need to consider the impact of monetary and fiscal policy on the economy. In the preceding series, we used the model of aggregate demand Opens in new window and aggregate supply Opens in new window to explain short-run economic fluctuations.

We saw that shifts in the aggregate-demand curve Opens in new window or the aggregate-supply curve Opens in new window cause fluctuations in the economy’s overall output of goods and services and its overall level of prices.

Both monetary and fiscal policy influence aggregate demand. Thus, a change in one of these policies can lead to short-run fluctuations in output and prices. Policymakers will want to anticipate this effect and, perhaps, adjust the other policy in response.

Here in this series, we examine in more detail how the government’s policy tools influence the position of the aggregate-demand curve.

These tools include monetary policy (the supply of money set by the central bank) and fiscal policy (the levels of government spending and taxation set by the president and Congress).

We are interested in how these policy tools can shift the aggregate-demand curve and thereby affect macroeconomic variables in the short-run. However, it is important to note many factors influence aggregate-demand besides monetary and fiscal policy.

In particular, desired spending by households and firms determines the overall demand for goods and services. When desired spending changes, aggregate demand shifts.

If policymakers do not respond, such shifts in aggregated demand cause short-run fluctuations in output and employment.

As a result, monetary and fiscal policymakers sometimes use the policy levers at their disposal to try to offset these shifts in aggregate demand and stabilize the economy. Here we discuss the theory behind these policy actions and some of the difficulties that arise in using this theory in practice.

How Monetary Policy Influences Aggregate Demand

The aggregate-demand curve Opens in new window shows the total quantity of goods and services demanded in the economy for any price level. There are three reasons why the aggregate-demand curve sloped upward:

  • The wealth effect: A lower price level raises the real value of household’s money holdings, which are part of their wealth. Higher real wealth stimulates consumer spending and thus increases the quantity of goods and services demanded.
  • The interest-rate effect: A lower price level reduces the amount of money people want to hold. As people try to lend out their excess money holdings, the interest rate falls. The lower interest rate stimulates 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 move some of their funds overseas in search of higher returns.

    This movement of funds causes the real value of the domestic currency to fall in the market for foreign-currency exchange. Domestic goods become less expensive relative to foreign goods. This change in the real exchange rate stimulates spending on net exports and thus increases the quantity of goods and services demanded.

These three effects occur simultaneous to increase the quantify of goods and services demanded when the price level falls and to decrease it when the price level rises. Although all three effects work together to explain the downward slope o the aggregate-demand curve, they are not equal importance.

Because money holdings are a small part of household wealth, the wealth effect is the least important of the three.

In addition, because exports and imports represent only a small fraction of U.S. GDP, the exchange-rate effect is not large for the U.S. economy. (This effect is more important for smaller countries, which typically export and import a higher fraction of their GDP.) For the U.S. economy, the most important reason for the downward slope of the aggregate-demand curve is the interest-rate effect.

To better understand aggregate demand, we now examine the short-run determination of interest rates in more detail. Here we develop the theory of liquidity preference Opens in new window.

This theory of interest rates helps explain the downward slope of the aggregate-demand curve, as well as how monetary and fiscal policy can shift this curve.

By shedding new light on aggregate demand, the theory of liquidity preference expands our understanding of what causes short-run economic fluctuations and what policymakers can potentially do about them.