Quiz 24: The Influence of Monetary and Fiscal Policy on Aggregate Demand

Aggregate Demand: Aggregate demand refers to the total demand for final goods and services in an economy at a given time that would be purchased at all possible price levels. It is also referred as the demand for the gross domestic product of a country. Aggregate demand curve shows the sum of consumer expenditure, government expenditure, investment and net export. Effect of Aggregate Demand Expansion: Central bank controls the money circulation in the economy. Money is the important factor to undertake aggregate expenditures, such as consumer spending, government spending, investment and net export. When there is an increase in the money supply, the aggregate expenditure increases and with a decrease in the money supply the aggregate demand decreases. If the central bank wants to expand the aggregate demand, then it can be done by increasing money supply in the economy which in turn will increase the purchasing power of all four sectors, such as household, business, government, and foreign country. The other determinant of aggregate demand, such as interest rate has to be decreased in order to boost the investment expenditures. Decrease in interest rate will also increase the household expenditures on durable goods. Hence, option 'b' is correct.

a. When the Fed's bond traders buy bonds in open-market operations, the money -supply curve shifts to the right from MS 1 to MS 2. The result is a decline in the interest rate. Change in Money supply b. When an increase in credit card availability reduces the cash people hold, the money-demand curve shifts to the left from MD 1 to MD 2. The result is a decline in the interest rate. Graphically, this can be seen as below: Change in Demand c. When the Federal Reserve reduces reserve requirements, the money supply increases, so the money-supply curve shifts to the right from MS 1 to MS 2. The result is a decline in the interest rate. The figure is same as in (a) d. When households decide to hold more money to use for holiday shopping, the money-demand curve shifts to the right from MD 1 to MD 2. The result is a rise in the interest rate. Figure 3 e. When a wave of optimism boosts business investment and expands aggregate demand, money demand increases from MD 1 to MD 2 in Figure 3. The increase in money demand increases the interest rate. Graphically, this can be seen as below: Figure 4

The theory of liquidity preference is Keynes's theory of how the interest rate is determined. According to the theory, the aggregate-demand curve slopes downward because: (1) A higher price level raises money demand; (2) Higher money demand leads to a higher interest rate; and (3) A higher interest rate reduces the quantity of goods and services demanded. Thus, the price level has a negative relationship with the quantity of goods and services demanded. The above three points illustrates the liquidity preference of Keynes's theory