Macroeconomics
HS 101
Vidhya Soundararajan
November 7, 2022
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
1 / 28
Aggregate Demand
Recall, the AD curve slopes downward for two reasons:
▶
▶
the wealth effect
the interest-rate effect
What is the interest-rate effect?
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
2 / 28
The theory of liquidity preferences help understand how the interest
rate effect works.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
3 / 28
Outline
1
The Theory of Liquidity Preference
2
Monetary Policy and Aggregate Demand
3
Fiscal Policy and Aggregate Demand
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
4 / 28
The Theory of Liquidity Preference
A simple theory of the interest rate (denoted r )
r adjusts to balance supply and demand for money
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
5 / 28
The Theory of Liquidity Preference
Money supply: assume fixed by central bank, does not depend on
interest rate
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
6 / 28
Money Demand
Money demand reflects how much wealth people want to hold in
liquid form.
For simplicity, suppose household wealth includes only two assets:
▶
▶
Money – liquid but pays no interest.
Bonds – pay interest but not as liquid as money.
A household’s “money demand” reflects its preference for liquidity.
Money demand is higher when r is lower.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
7 / 28
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
8 / 28
Theory of Liquidity Preferences
This theory says that interest rate adjusts to balance the supply and
demand for money.
At the equilibrium interest rate, the quantity of money demanded
exactly balances the quantity of money supply.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
9 / 28
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
10 / 28
What can the government do to increase aggregate demand?
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
11 / 28
What can the government do?
Monetary policy
Fiscal policy
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
12 / 28
Outline
1
The Theory of Liquidity Preference
2
Monetary Policy and Aggregate Demand
3
Fiscal Policy and Aggregate Demand
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
13 / 28
Monetary Policy and Aggregate Demand
To achieve macroeconomic goals, central banks can use monetary
policy to shift the AD curve.
The central bank’s policy instrument is the money supply.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
14 / 28
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
15 / 28
The Effects of Reducing the Money Supply
Note that the expansion of the money supply and subsequent interest
rate reduction increases the quantity of g & s demanded at each price
level.
Hence, the AD curve shifts right.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
16 / 28
Outline
1
The Theory of Liquidity Preference
2
Monetary Policy and Aggregate Demand
3
Fiscal Policy and Aggregate Demand
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
17 / 28
Fiscal Policy and Aggregate Demand
Fiscal policy: the setting of the level of govt spending and taxation by
govt policymakers.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
18 / 28
Fiscal Policy and Aggregate Demand
Expansionary fiscal policy:
▶
▶
an increase in G and/or decrease in T.
How does this shift the AD curve?
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
19 / 28
Fiscal Policy and Aggregate Demand
Expansionary fiscal policy:
▶
▶
an increase in G and/or decrease in T.
How does this shift the AD curve? shifts AD right.
Contractionary fiscal policy:
▶
▶
a decrease in G and/or increase in T.
How does this shift the AD curve?
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
19 / 28
Fiscal Policy and Aggregate Demand
Expansionary fiscal policy:
▶
▶
an increase in G and/or decrease in T.
How does this shift the AD curve? shifts AD right.
Contractionary fiscal policy:
▶
▶
a decrease in G and/or increase in T.
How does this shift the AD curve? shifts AD left.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
19 / 28
Fiscal Policy and Aggregate Demand
Fiscal policy has two opposing effects on AD:
1
Multiplier effect
2
Crowding out
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
20 / 28
The Multiplier Effect
If the govt buys $20b of planes from Boeing, Boeing’s revenue
increases by $20b.
This is distributed to Boeing’s workers (as wages) and owners (as
profits or stock dividends).
These people are also consumers, and will spend a portion of the
extra income.
This extra consumption causes further increases in aggregate demand.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
21 / 28
The Multiplier Effect
Multiplier Effect
The additional shifts in AD that result when fiscal policy increases income
and thereby increases consumer spending.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
22 / 28
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
23 / 28
Marginal Propensity to Consume
How big is the multiplier effect?
It depends on how much consumers respond to increases in income.
Marginal propensity to consume (MPC): the fraction of extra income
that households consume rather than save.
e.g., if MPC = 0.8 and income rises $100, then, C rises $80.
The higher the MPC, the higher the multiplier effect.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
24 / 28
The Crowding-Out Effect
Fiscal policy has another effect on AD that works in the opposite
direction.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
25 / 28
The Crowding-Out Effect
A fiscal expansion shifts AD to the right, resulting in increase in
output (income).
Higher Y increases demand for money and hence raises r.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
26 / 28
The Crowding-Out Effect
Higher r reduces investment and, thus, reduces the net increase in
aggregate demand.
So, the size of the AD shift may be smaller than the initial fiscal
expansion.
This is called the crowding-out effect.
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
27 / 28
Vidhya Soundararajan
Macroeconomics HS 101
November 7, 2022
28 / 28