Principles of
Economics, 10e
Chapter 35: The Influence of
Monetary and Fiscal Policy
on Aggregate Demand
Mankiw, Principles of Economics, Tenth Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part. 1
Chapter Objectives (1 of 3)
By the end of this chapter, you should be able to:
• Derive the short-run and long-run effects on output and prices
according to the AD-AS model, given a scenario about an economic
shock.
• Illustrate the short-run impact of a change in the price level under
liquidity preference theory according to the model of aggregate demand
and aggregate supply.
• Explain how open market operations impact the money supply.
• Explain the benefits and challenges of using monetary policy to address
economic imbalances.
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or duplicated, or posted to a publicly accessible website, in whole or in part. 2
Chapter Objectives (2 of 3)
• Describe the concept of a liquidity trap.
• Explain the benefits and challenges of using fiscal policy to address
economic imbalances.
• Given a graph of the aggregate-demand curve, determine the effect of
a change in fiscal policy on that curve.
• Explain the multiplier effect of a change in fiscal policy.
• Explain how expansionary fiscal policy causes crowding out.
• Explain how government borrowing can lead to crowding out.
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or duplicated, or posted to a publicly accessible website, in whole or in part. 3
Chapter Objectives (3 of 3)
• Explain the effect of tax policy on aggregate demand.
• Given a scenario about an economy's current state, determine the
appropriate stabilization policy to restore the natural rate of output.
• Discuss the pros and cons of employing stabilization policies.
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or duplicated, or posted to a publicly accessible website, in whole or in part. 4
35-1
How Monetary Policy Influences Aggregate
Demand
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Aggregate Demand (1 of 2)
• Aggregate-demand (AD) curve slopes downward for three reasons
• The wealth effect
• The interest-rate effect
• The exchange-rate effect
• These three effects work simultaneously to increase the quantity of
goods and services demanded when the price level falls (opposite
occurs when the price level rises)
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or duplicated, or posted to a publicly accessible website, in whole or in part. 6
Aggregate Demand (2 of 2)
• For the U.S. economy
• Wealth effect is least important
• Money holdings are a small part of household wealth
• The exchange-rate effect is not large
• Exports and imports are a small fraction of GDP
• The interest-rate effect is the most important reason for the
downward slope of the aggregate-demand curve
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The Theory of Liquidity Preference
• Theory of liquidity preference*
• Keynes’s theory that the interest rate adjusts to bring money supply
and money demand into balance
• Nominal interest rate and real interest rate
• Assumption: Expected rate of inflation is constant
*Words accompanied by an asterisk are key terms from the chapter.
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Figure 1 Equilibrium in the Money
Market (1 of 2)
According to the theory of liquidity preference, the interest rate adjusts to bring the
quantity of money supplied and the quantity of money demanded into balance. If the
interest rate is above the equilibrium level (such as at r1), the quantity of money people
want to hold (𝑀1𝑑 ) is less than the quantity the Fed has created, and this surplus puts
downward pressure on the interest rate. Conversely, if the interest rate is below the
equilibrium level (such as at r2), the quantity of money people want to hold (𝑀2𝑑 )
exceeds the quantity the Fed has created, and this shortage puts upward pressure on
the interest rate. In this manner, the theory says, the forces of supply and demand in
the market for money push the interest rate toward the equilibrium interest rate at
which people are content holding the quantity of money the Fed has created.
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Figure 1 Equilibrium in the Money
Market (2 of 2)
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or duplicated, or posted to a publicly accessible website, in whole or in part. 10
Active Learning 1: Determinants of Money
Demand
• What happens to money demand in the following two scenarios?
A. Suppose r rises, but Y and P are unchanged
B. Suppose P rises, but Y and r are unchanged
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Active Learning 1: Answers
A. Recall that r is the opportunity cost of holding money
• An increase in r reduces the quantity of money demanded: Households attempt to
buy bonds to take advantage of the higher interest rate
• Hence, an increase in r causes a decrease in the quantity of money demanded,
other things equal
B. If Y is unchanged, people will want to buy the same amount of goods and services
• Since P is higher, they will need more money to do so
• Hence, an increase in P causes an increase in money demand, other things equal
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Money Supply
• Money supply
• Assumed fixed by the Fed, does not depend on interest rate
• Tools the Fed uses to change the money supply
• Open market operations
• Change the interest rate it pays on reserves
• Change reserve requirements
• Change the discount rate
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Money Demand
• Money demand
• Reflects how much wealth people want to hold in liquid form
• Assume household wealth includes only two assets
• Cash – liquid but pays no interest
• Bonds – pay interest but not as liquid
• A household’s “money demand” reflects its preference for liquidity
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Equilibrium in the Money Market (1 of 2)
• According to the theory of liquidity preference, the interest rate adjusts
to balance the supply and demand for money
• Equilibrium interest rate
• Quantity of money demanded exactly balances the quantity of
money supplied
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or duplicated, or posted to a publicly accessible website, in whole or in part. 15
Equilibrium in the Money Market (2 of 2)
• If interest rate > equilibrium • If interest rate < equilibrium
• Quantity of money people • Quantity of money people
want to hold less than want to hold more than
quantity supplied quantity supplied
• People holding the surplus buy • People increase their holdings
interest-bearing assets of money sell interest-bearing
assets
• Interest rate falls
• Interest rates rises
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The Downward Slope of the Aggregate-
Demand Curve
• Negative relationship between the price level and the quantity of goods
and services demanded
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
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or duplicated, or posted to a publicly accessible website, in whole or in part. 17
Figure 2 The Money Market and the Slope
of the Aggregate-Demand Curve (1 of 2)
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 by a
downward-sloping aggregate-demand curve, as in panel (b).
Mankiw, Principles of Economics, Tenth Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part. 18
Figure 2 The Money Market and the Slope
of the Aggregate-Demand Curve (2 of 2)
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or duplicated, or posted to a publicly accessible website, in whole or in part. 19
Changes in the Money Supply
• When the Fed increases the money supply
• Lowers the interest rate and increases the quantity of goods and
services demanded for any price level
• Aggregate-demand curve shifts to the right
• When the Fed contracts the money supply
• Raises the interest rate and reduces the quantity of goods and
services demanded for any price level
• Aggregate-demand curve to the left
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or duplicated, or posted to a publicly accessible website, in whole or in part. 20
Figure 3 A Monetary Injection
In panel (a), an increase in the money supply from MS1 to MS2 reduces the equilibrium interest
rate from r1 to r2. When the interest rate falls, the cost of borrowing drops, raising the quantity of
goods and services demanded at a given price level from Y1 to Y2. In panel (b), therefore, the
aggregate-demand curve shifts to the right from AD1 to AD2.
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or duplicated, or posted to a publicly accessible website, in whole or in part. 21
The Role of Interest-Rate Targets in Fed Policy
• Monetary policy can be described either in terms of the money supply
or in terms of the interest rate
• Changes in monetary policy aimed at expanding aggregate demand
can be described either as increasing the money supply or as
reducing 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
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or duplicated, or posted to a publicly accessible website, in whole or in part. 22
Active Learning 2: Monetary Policy
• For each of the events below
• Determine the short-run effects on output
• Determine how the Fed should adjust the money supply and interest
rates to stabilize output
A. Congress tries to balance the budget by cutting government
spending
B. A stock market boom increases household wealth
C. War breaks out in the Middle East, causing oil prices to soar
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or duplicated, or posted to a publicly accessible website, in whole or in part. 23
Active Learning 2: Answers
A. Cutting government spending would reduce aggregate demand and
output. To stabilize output, the Fed should increase MS and reduce r
to increase aggregate demand.
B. Increased household wealth would increase aggregate demand, raising
output above its natural rate.
C. To stabilize output, the Fed should reduce MS and increase r to
reduce aggregate demand.
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or duplicated, or posted to a publicly accessible website, in whole or in part. 24
The Zero Lower Bound (1 of 2)
• Liquidity trap
• If interest rates have already fallen to around zero, monetary policy
may no longer be effective
• Aggregate demand, production, and employment may be “trapped”
at low levels
• Zero lower bound for interest rates justifies setting the target rate of
inflation higher
• Moderate inflation gives monetary policymakers more room to
stimulate the economy when needed
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The Zero Lower Bound (2 of 2)
• A central bank has other tools to expand the economy even after its
interest rate target hits its lower bound of zero
• Forward guidance: Raise inflation expectations by committing to
keep interest rates low
• Quantitative easing: Buy a larger variety of financial instruments
(mortgages, corporate debt, and longer-term government bonds)
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or duplicated, or posted to a publicly accessible website, in whole or in part. 26
35-2
How Fiscal Policy Influences Aggregate
Demand
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Fiscal Policy
• Fiscal policy*
• The setting of the levels of government spending and taxation by
government policymakers by government policymakers
*Words accompanied by an asterisk are key terms from the chapter.
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Changes in Government Purchases
• When the government alters its own purchases of goods and services,
it shifts the aggregate-demand curve directly
• Two macroeconomic effects cause the size of the shift in aggregate
demand to differ from the change in government purchases
• The multiplier effect suggests the shift in aggregate demand could
be larger
• The crowding-out effect suggests the shift in aggregate demand
could be smaller
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or duplicated, or posted to a publicly accessible website, in whole or in part. 29
The Multiplier Effect
• Multiplier effect*
• Additional shifts in aggregate demand that result when expansionary
fiscal policy increases income and thereby increases consumer
spending
*Words accompanied by an asterisk are key terms from the chapter.
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A Formula for the Spending Multiplier
• How big is the multiplier effect?
• Depends on how much consumers respond to increases in income
• Marginal propensity to consume (MPC)
• Fraction of extra income that households consume rather than save
• For example, if the MPC is ¾, for every extra dollar a household earns,
the household spends $0.75 (¾ of the dollar) and saves $0.25
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Spending Multiplier Example (1 of 2)
• With an MPC of ¾ when the workers and owners of Boeing earn $20
billion from the government contract, they increase their consumer
spending by
• ¾ × $20 billion = $15 billion
• Additional consumer spending raises income for the workers and
owners of the firms that produce the consumption goods by the same
amount
• Consumers increase spending again, this time by MPC × (MPC × $20
billion)
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or duplicated, or posted to a publicly accessible website, in whole or in part. 32
Spending Multiplier Example (2 of 2)
• Spending multiplier = 1/(1 – MPC)
Change in government purchases $ 20 billion
First change in consumption MPC × $ 20 billion
Second change in consumption MPC2 × $ 20 billion
Third Change in consumption MPC3 × $ 20 billion
Etc. Etc.
Total change in demand = (1 + MPC + MPC2 + MPC3 + …) × $20 billion
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Figure 4 The Multiplier Effect
• An increase in government purchases of
$20 billion can shift the aggregate-
demand curve to the right by more than
$20 billion.
• This multiplier effect arises because
increases in aggregate income stimulate
additional spending by consumers.
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or duplicated, or posted to a publicly accessible website, in whole or in part. 34
Other Applications of the Multiplier Effect
• The multiplier effect tends to amplify the effects of fiscal policy on
aggregate demand
• Also applies to any event that alters spending on any component of
GDP—consumption, investment, government purchases, or net
exports
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The Crowding-Out Effect
• Crowding-out effect*
• The offset in aggregate demand that results when expansionary
fiscal policy raises the interest rate and thereby reduces investment
spending
• Reduces the net increase in aggregate demand
• The size of the AD shift may be smaller than the initial fiscal
expansion
*Words accompanied by an asterisk are key terms from the chapter.
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or duplicated, or posted to a publicly accessible website, in whole or in part. 36
Figure 5 The Crowding-Out Effect (1 of 2)
Panel (a) shows the money market. When the government increases its purchases of
goods and services, income increases, raising the demand for money from MD1 to MD2
and increasing the equilibrium interest rate from r1 to r2. Panel (b) shows the effects on
aggregate demand. The initial impact of the increase in government purchases shifts
the aggregate-demand curve from AD1 to AD2. Yet because the interest rate is the cost
of borrowing, the increase in the interest rate tends to reduce the quantity of goods
and services demanded, particularly for investment goods. This crowding out of
investment partially offsets the impact of the fiscal expansion on aggregate demand. In
the end, the aggregate-demand curve shifts only to AD3.
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Figure 5 The Crowding-Out Effect (2 of 2)
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Changes in Taxes
• A tax cut
• Increases households’ take-home pay
• Households respond by spending a portion of this extra income, shifting AD to the
right
• The size of the shift is affected by the multiplier and crowding-out effects
• Another factor: Households’ perception
• Permanent tax cut – large impact on AD
• Temporary tax cut – small impact on AD
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Active Learning 3: Fiscal Policy Effects
• The economy is in recession. Policymakers think that shifting the AD
curve rightward by $200 billion would end the recession.
A. If MPC = 0.8 and there is no crowding out, how much should
Congress increase G
to end the recession?
B. If there is crowding out, will Congress need to increase G more or
less than this amount?
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or duplicated, or posted to a publicly accessible website, in whole or in part. 40
Active Learning 3: Answers
A. Multiplier = 1 / (1-MPS) = 1/(1 − .8) = 5
• Increase G by $40B to shift aggregate demand by
• ∆Y = multiplier × ∆G = 5 × $40b = $200B
B. Crowding out reduces the impact of G on AD. To offset this, Congress
should increase G by a larger amount.
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35-3
Using Policy to Stabilize the Economy
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The Case for Active Stabilization Policy
(1 of 2)
• Advocates of active stabilization policy say that changes in attitudes by
households and firms shift aggregate demand and that, if the
government does not respond, the result is undesirable and
unnecessary fluctuations in output and employment
• Keynes emphasized key role of aggregate demand in explaining
short-run fluctuations
• Aggregate demand fluctuates because of largely irrational waves of
pessimism and optimism (animal spirits)
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The Case for Active Stabilization
Policy (2 of 2)
• Government should use policy to reduce these fluctuations
• When GDP falls below its natural rate, use expansionary monetary or
fiscal policy to prevent or reduce a recession
• When GDP rises above its natural rate, use contractionary policy to
prevent or reduce an inflationary boom
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or duplicated, or posted to a publicly accessible website, in whole or in part. 44
The Case against Active Stabilization Policy
(1 of 2)
• Advocates of more passive policy say that monetary and fiscal policy
work with such long lags that attempts at stabilizing the economy
often end up being destabilizing
• Monetary policy affects economy with a long lag
• Firms make investment plans in advance, so I takes time to respond
to changes in r
• Fiscal policy also works with a long lag
• Changes in G and T require acts of Congress and legislative process
can take months or years
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or duplicated, or posted to a publicly accessible website, in whole or in part. 45
The Case against Active Stabilization Policy
(2 of 2)
• Due to these long lags
• Critics of active policy argue that such policies may destabilize the
economy rather than help it
• By the time the policies affect aggregate demand, the economy’s
condition may have changed
• Contend that policymakers should focus on long-run goals like
economic growth and low inflation
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or duplicated, or posted to a publicly accessible website, in whole or in part. 46
Automatic Stabilizers (1 of 2)
• Automatic stabilizers*
• Changes in fiscal policy that stimulate aggregate demand when the
economy goes into a recession but that occur without policymakers
having to take any deliberate action
*Words accompanied by an asterisk are key terms from the chapter.
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Automatic Stabilizers (2 of 2)
• The tax system
• In recession, taxes fall automatically, which stimulates aggregate
demand
• Some government spending
• In recession, more people apply for public assistance (welfare,
unemployment insurance)
• Government spending on these programs automatically rises, which
stimulates aggregate demand
• Automatic stabilizers in the U.S. economy are not sufficiently strong to
prevent recessions completely
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35-4
Conclusion
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Conclusion
• Policy instruments influence the aggregate demand for goods and
services
• Time horizons are important
• When Congress alters government spending or taxes, it needs to consider both
the long-run effects on growth and the short-run effects on employment
• When the Fed changes the money supply and interest rates, it must recognize the
long-run effect on inflation as well as the short-run effect on production
• In all parts of government, policymakers must keep in mind both long-run and
short-run goals
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Think-Pair-Share Activity
The news reports that the Fed raised interest rates by a quarter of a percent today to head off
future inflation. The report then moves to interviews with prominent politicians. The response of
a member of Congress to the Fed’s move is negative. She says, “The Consumer Price Index has
not increased, yet the Fed is restricting growth in the economy, supposedly to fight inflation. My
constituents will want to know why they are going to have to pay more when they get a loan, and
I don’t have a good answer. I think this is an outrage and I think Congress should have hearings
on the Fed’s policymaking powers.”
A. What interest rate did the Fed raise?
B. State the Fed’s policy in terms of the money supply.
C. Why might the Fed raise interest rates before the CPI starts to rise?
D. Many economists believe that the Fed needs to be independent of politics. Use the
congresswoman’s statement to explain why so many economists argue for Fed independence
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Self-Assessment
• Suppose that survey measures of consumer confidence indicate a wave
of pessimism is sweeping the country. If policymakers do nothing, what
will happen to aggregate demand? What should the Fed do? If the Fed
does nothing, what might Congress do?
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