PowerPoint Presentations for
Principles of Macroeconomics
Sixth Canadian Edition
by Mankiw/Kneebone/McKenzie
Adapted for the
Sixth Canadian Edition by
Marc Prud’homme
University of Ottawa
THE INFLUENCE
OF MONETARY AND
FISCAL POLICY ON
AGGREGATE
DEMAND
Chapter 15
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THE INFLUENCE OF MONETARY AND
FISCAL POLICY ON AGGREGATE DEMAND
 In this chapter we examine in more detail how
the government’s tools of monetary and fiscal
policy influence the position of the aggregatedemand curve.
 We will also see how the tools of monetary and
fiscal policy can shift the aggregate-demand
curve and, in doing so, affect short-run economic
fluctuations.
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HOW MONETARY POLICY
INFLUENCES AGGREGATE DEMAND
 The aggregate-demand curve slopes downward
for three reasons:
1. The Wealth Effect
2. The Interest Rate Effect
3. The Real Exchange Rate Effect
 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
The theory of liquidity preference: Keynes’s
theory that the interest rate adjusts to bring
money supply and money demand into
balance.
In the analysis that follows, the expected
rate of inflation is held constant.
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The Theory of Liquidity Preference:
Money Supply
The Bank of Canada alters the money
supply using two methods:
 Changing the bank rate
 Open-market operations
 Buying and selling federal government bonds
 Foreign-exchange market operations
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FIGURE 15.1:
The Supply of Money
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The Theory of Liquidity Preference:
Money Demand
 Although many factors determine the quantity of
money demanded, the one emphasized by the
theory of liquidity preference is the interest rate.
 The other key determinant of the quantity of
money demanded is the fact that money is used
to buy goods and services.
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The Theory of Liquidity Preference:
Equilibrium in the Money Market
 According to the theory of liquidity preference,
the interest rate adjusts to balance the supply
and demand for money.
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FIGURE 15.2:
The Demand for Money
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FIGURE 15.3:
Shifts in the Demand for Money
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FIGURE 15.4:
Equilibrium in the Money Market
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The Downward Slope
of the Aggregate-Demand Curve
 What are the implications of the theory of
liquidity preference for the aggregate demand
for goods and services?
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FIGURE 15.5:
The Money Market and the Slope of the Aggregate-Demand Curve
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Changes in the Money Supply
 One important variable that shifts the aggregatedemand curve is monetary policy.
 To see how monetary policy affects the
economy in the short run, suppose that the Bank
of Canada causes the money supply to increase.
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FIGURE 15.6:
A Monetary Injection in a Closed Economy
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Open-Economy Considerations
 How does a monetary
injection affect the
aggregate-demand
curve in a small open
economy?
Dirk Ercken /Shutterstock
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FIGURE 15.7:
A Monetary Injection in an Open Economy
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Open-Economy Considerations:
Flexible Exchange Rate
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 Flexible exchange rate: a
policy by which the value
of the exchange rate is
allowed to vary without
interference by the central
bank
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Open-Economy Considerations:
Flexible Exchange Rate
 In a small open economy with a flexible exchange rate,
a monetary injection by the Bank of Canada causes the
dollar to depreciate in value.
 This causes an increase in the demand for Canadianproduced goods and services that is not realized in a
closed economy.
 In the end, a monetary injection in an open economy
shifts the aggregate-demand curve farther to the right
than it does in a closed economy.
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Open-Economy Considerations:
Fixed Exchange Rate
 Fixed exchange rate: a policy by which the
value of the exchange rate is held fixed by the
central bank
 The Bank of Canada cannot simultaneously
choose the size of the money supply and the
value of the Canadian dollar.
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TABLE 15.1:
A Monetary Injection in an Open Economy
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QuickQuiz
Explain how a decrease in the money
supply affects the money market and the
position of the aggregate-demand curve.
What is the effect for a closed economy
and for a small open economy?
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The Multiplier Effect
Multiplier effect: the additional shifts in
aggregate demand that result when
expansionary fiscal policy increases income
and thereby increases consumer spending
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FIGURE 15.8:
The Multiplier Effect
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Multiplier Effect
 This multiplier effect arising from the response of
consumer spending can be strengthened by the
response of investment to higher levels of
demand.
 This positive feedback from demand to
investment is sometimes called the investment
accelerator.
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A Formula for the Spending Multiplier
 An important number in this formula is the
marginal propensity to consume (MPC): the
fraction of extra income that a household
consumes rather than saves.
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A Formula for the Spending Multiplier
Change in GVT purchases
=
$5 billion
First change in Consumption
= MPC X
$5 billion
Second change in Consumption
= MPC2 X
$5 billion
Third change in Consumption
= MPC3 X
$5 billion
.
.
.
.
.
.
Total change in demand = (1 + MPC + MPC2 + MPC3 + …) x 5 billion
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A Formula for the Spending Multiplier
Multiplier = 1 + MPC + MPC2 + MPC3 + …
Multiplier = 1 / (1 – MPC)
In an open economy:
 Multiplier = 1 / (1 – MPC + MPI)
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Other Applications of the Multiplier Effect
The multiplier effect applies to any event
that alters spending on any component of
GDP:
 Consumption
 Investment
 Government purchases
 Net exports
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The Crowding-Out Effect on Investment
 Crowding-out effect on investment: the offset in
aggregate demand that results when
expansionary fiscal policy raises the interest rate
and thereby reduces investment spending
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FIGURE 15.9:
The Crowding-Out Effect on Investment
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Open-Economy Considerations
 So far the effects of fiscal policy on aggregate
demand have ignored open-economy
considerations.
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Open-Economy Considerations:
Flexible Exchange Rate
 In a small open economy, an expansionary fiscal
policy causes the dollar to appreciate.
 Because this appreciation of the dollar causes
net exports to fall, there is an additional
crowding-out effect that reduces the demand
for Canadian-produced goods and services.
 In the end, fiscal policy has no lasting effect on
aggregate demand.
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FIGURE 15.10:
A Fiscal Expansion in an Open Economy with a Flexible Exchange Rate
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Open-Economy Considerations
 Crowding-out effect on net exports: the offset in
aggregate demand that results when
expansionary fiscal policy in a small open
economy with a flexible exchange rate raises the
real exchange rate and thereby reduces net
exports
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Open-Economy Considerations:
Fixed Exchange Rate
 If the Bank of Canada chooses to prevent any
change in the exchange rate, expansionary
fiscal policy will have no crowding-out effects
and will therefore cause a very large increase in
the demand for goods and services.
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FIGURE 15.11:
A Fiscal Expansion in an Open Economy with a Fixed Exchange Rate
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Open-Economy Considerations:
The Coordination of Monetary and Fiscal Policy
 For fiscal policy to have a lasting effect on the
position of the aggregate-demand curve, the
Bank of Canada must choose the appropriate
exchange rate policy.
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Changes in Taxes
 The other important instrument of fiscal policy,
besides the level of government purchases, is the
level of taxation.
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Deficit Reduction
 During the 1990s and 2000s, Canadian
governments at both the federal and the
provincial levels took steps to reduce or eliminate
their budget deficits.
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QuickQuiz
Explain how a decrease in government
expenditures affects the money market and the
position of the aggregate-demand curve.
What is the effect for (a) a closed economy and
(b) an open economy when the Bank of Canada
allows the exchange rate to vary, and for (c) an
open economy when the Bank of Canada
chooses to maintain a fixed value for the
exchange rate?
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Active Learning
Exercise
The economy is in recession. Shifting the AD
curve rightward by $20b would end the
recession.
A. If MPC = 0.8 and there is no crowding out,
how much should the government increase
G to end the recession?
B. If there is crowding out, will the government
need to increase G more or less than this
amount?
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Active Learning
Answers
The economy is in recession. Shifting the AD curve
rightward by $20b would end the recession.
A. If MPC = 0.8 and there is no crowding out,
how much should the government increase
G to end the recession?
Multiplier = 1 / (1 – 0.8) = 5
Increase G by $4b
to shift aggregate demand by 5 x $4b = $20b.
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Active Learning
Answers
The economy is in recession. Shifting the AD curve
rightward by $20b would end the recession.
B. If there is crowding out, will the government
need to increase G more or less than this
amount?
Crowding out reduces the impact of G on AD.
To offset this, the government should increase
G by a larger amount.
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USING POLICY TO
STABILIZE THE ECONOMY
 The case for active stabilization policy:
 Keynes claimed that the government should actively
stimulate aggregate demand when aggregate
demand appeared insufficient to maintain
production at its full-employment level.
 The case against active stabilization policy:
 The primary argument against active monetary and
fiscal policy is that these policies affect the economy
with a long lag.
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Automatic Stabilizers
 Automatic stabilizers: changes in fiscal policy
that stimulate aggregate demand when the
economy goes into a recession, without policy
makers having to take any deliberate action
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A Flexible Exchange Rate
as an Automatic Stabilizer
 In an open economy, policy makers can choose
to make use of another type of automatic
stabilizer: a flexible exchange rate.
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QuickQuiz
How does a reduction in government spending
affect the aggregate-demand curve?
How does your answer differ if we consider a
closed economy versus an open economy?
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Classroom Activity
Politics and Policy
1. Find a current political proposal that would have economic implications.
This can be a campaign promise by a candidate or a policy proposal by an
office-holder.
2. Name the politician and briefly describe the proposal.
3. Consider the economic implications of this proposal. Is it more likely to
affect aggregate demand or aggregate supply? Explain how this proposal
would change the aggregate-demand curve—through consumption,
investment, government spending, or net exports—or the aggregatesupply curve—through labour, capital, natural resources, or technology.
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Classroom Activity
Politics and Policy (continued)
4. Graph the impact of this proposal using aggregate demand and aggregate
supply. Explain what happens to the price level and the level of output.
5. Does this policy seem to be appropriate given the current economic
conditions? Explain.
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THE END
Chapter 15
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