Eco 29 Chapter The Monetary Policy and Aggregate Demand Curve Study Policy Curve Monetary Policy Curve - indicates relationship between real. 1. monetary policy(MP) curve – indicates the relationship between real in- terest rate r the Chapter Aggregate Demand and Supply Analysis. Aggregate. A. Tightening of monetary policy shifts the aggregate demand curve to the right, D. It indicates the relationship between the inflation rate and the real interest rate . B. When inflation increases, the supply of real money balances increases.
The aggregate supply curve slopes up because when the price level for outputs increases while the price level of inputs remains fixed, the opportunity for additional profits encourages more production. Potential GDP, or full-employment GDP, is the maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions.
Aggregate demand is the amount of total spending on domestic goods and services in an economy.
Aggregate demand and aggregate supply curves (article) | Khan Academy
The downward-sloping aggregate demand curve shows the relationship between the price level for outputs and the quantity of total spending in the economy.
Introduction To understand and use a macroeconomic model, we first need to understand how the average price of all goods and services produced in an economy affects the total quantity of output and the total amount of spending on goods and services in that economy. The aggregate supply curve Firms make decisions about what quantity to supply based on the profits they expect to earn.
Profits, in turn, are also determined by the price of the outputs the firm sells and by the price of the inputs—like labor or raw materials—the firm needs to buy.
Aggregate supply, or AS, refers to the total quantity of output—in other words, real GDP—firms will produce and sell. The aggregate supply curve shows the total quantity of output—real GDP—that firms will produce and sell at each price level. The graph below shows an aggregate supply curve. Let's begin by walking through the elements of the diagram one at a time: The graph shows an upward sloping aggregate supply curve. The slope is gradual between 6, and 9, before become steeper, especially between 9, and 9, The aggregate supply curve.
The vertical axis shows the price level. Price level is the average price of all goods and services produced in the economy. It's an index number, like the GDP deflator. Wait, what's a GDP deflator again? The GDP deflator is a price index measuring the average prices of all goods and services included in the economy.
Notice on the graph that as the price level rises, the aggregate supply—quantity of goods and services supplied—rises as well. Why do you think this is? The price level shown on the vertical axis represents prices for final goods or outputs bought in the economy, not the price level for intermediate goods and services that are inputs to production.
The AS curve describes how suppliers will react to a higher price level for final outputs of goods and services while the prices of inputs like labor and energy remain constant. If firms across the economy face a situation where the price level of what they produce and sell is rising but their costs of production are not rising, then the lure of higher profits will induce them to expand production.
Potential GDP If you look at our example graph above, you'll see that the slope of the AS curve changes from nearly flat at its far left to nearly vertical at its far right.
At the far left of the aggregate supply curve, the level of output in the economy is far below potential GDP—the quantity that an economy can produce by fully employing its existing levels of labor, physical capital, and technology, in the context of its existing market and legal institutions.
At these relatively low levels of output, levels of unemployment are high, and many factories are running only part-time or have closed their doors. In this situation, a relatively small increase in the prices of the outputs that businesses sell—with no rise in input prices—can encourage a considerable surge in the quantity of aggregate supply—real GDP—because so many workers and factories are ready to swing into production.
That is a choice each household must make—it is a question of weighing the interest a bond fund strategy creates against the hassle and possible fees associated with the transfers it requires. Our example does not yield a clear-cut choice for any one household, but we can make some generalizations about its implications. First, a household is more likely to adopt a bond fund strategy when the interest rate is higher.
At low interest rates, a household does not sacrifice much income by pursuing the simpler cash strategy. As the interest rate rises, a bond fund strategy becomes more attractive.
That means that the higher the interest rate, the lower the quantity of money demanded.
Second, people are more likely to use a bond fund strategy when the cost of transferring funds is lower. The creation of savings plans, which began in the s and s, that allowed easy transfer of funds between interest-earning assets and checkable deposits tended to reduce the demand for money.
Some money deposits, such as savings accounts and money market deposit accounts, pay interest. In evaluating the choice between holding assets as some form of money or in other forms such as bonds, households will look at the differential between what those funds pay and what they could earn in the bond market.
A higher interest rate in the bond market is likely to increase this differential; a lower interest rate will reduce it. An increase in the spread between rates on money deposits and the interest rate in the bond market reduces the quantity of money demanded; a reduction in the spread increases the quantity of money demanded.
Firms, too, must determine how to manage their earnings and expenditures. How is the speculative demand for money related to interest rates? When financial investors believe that the prices of bonds and other assets will fall, their speculative demand for money goes up.
The speculative demand for money thus depends on expectations about future changes in asset prices. Will this demand also be affected by present interest rates? If interest rates are low, bond prices are high. It seems likely that if bond prices are high, financial investors will become concerned that bond prices might fall. That suggests that high bond prices—low interest rates—would increase the quantity of money held for speculative purposes. Conversely, if bond prices are already relatively low, it is likely that fewer financial investors will expect them to fall still further.
They will hold smaller speculative balances. Economists thus expect that the quantity of money demanded for speculative reasons will vary negatively with the interest rate. The Demand Curve for Money We have seen that the transactions, precautionary, and speculative demands for money vary negatively with the interest rate.
Putting those three sources of demand together, we can draw a demand curve for money to show how the interest rate affects the total quantity of money people hold.
The demand curve for money Curve that shows the quantity of money demanded at each interest rate, all other things unchanged. Such a curve is shown in Figure An increase in the interest rate reduces the quantity of money demanded. A reduction in the interest rate increases the quantity of money demanded. Its downward slope expresses the negative relationship between the quantity of money demanded and the interest rate. The relationship between interest rates and the quantity of money demanded is an application of the law of demand.
If we think of the alternative to holding money as holding bonds, then the interest rate—or the differential between the interest rate in the bond market and the interest paid on money deposits—represents the price of holding money. As is the case with all goods and services, an increase in price reduces the quantity demanded. Other Determinants of the Demand for Money We draw the demand curve for money to show the quantity of money people will hold at each interest rate, all other determinants of money demand unchanged.
Among the most important variables that can shift the demand for money are the level of income and real GDP, the price level, expectations, transfer costs, and preferences. That relationship suggests that money is a normal good: An increase in real GDP increases incomes throughout the economy. The demand for money in the economy is therefore likely to be greater when real GDP is greater. The Price Level The higher the price level, the more money is required to purchase a given quantity of goods and services.
All other things unchanged, the higher the price level, the greater the demand for money. Expectations The speculative demand for money is based on expectations about bond prices. All other things unchanged, if people expect bond prices to fall, they will increase their demand for money.
If they expect bond prices to rise, they will reduce their demand for money. The expectation that bond prices are about to change actually causes bond prices to change. If people expect bond prices to fall, for example, they will sell their bonds, exchanging them for money. That will shift the supply curve for bonds to the right, thus lowering their price. The importance of expectations in moving markets can lead to a self-fulfilling prophecy. Expectations about future price levels also affect the demand for money.
The expectation of a higher price level means that people expect the money they are holding to fall in value. Given that expectation, they are likely to hold less of it in anticipation of a jump in prices. Expectations about future price levels play a particularly important role during periods of hyperinflation. If prices rise very rapidly and people expect them to continue rising, people are likely to try to reduce the amount of money they hold, knowing that it will fall in value as it sits in their wallets or their bank accounts.
Toward the end of the great German hyperinflation of the early s, prices were doubling as often as three times a day. Under those circumstances, people tried not to hold money even for a few minutes—within the space of eight hours money would lose half its value! Transfer Costs For a given level of expenditures, reducing the quantity of money demanded requires more frequent transfers between nonmoney and money deposits.
As the cost of such transfers rises, some consumers will choose to make fewer of them. They will therefore increase the quantity of money they demand. In general, the demand for money will increase as it becomes more expensive to transfer between money and nonmoney accounts. The demand for money will fall if transfer costs decline.
In recent years, transfer costs have fallen, leading to a decrease in money demand. Preferences Preferences also play a role in determining the demand for money.
Some people place a high value on having a considerable amount of money on hand. For others, this may not be important.IS-LM: Fiscal & monetary policy
Household attitudes toward risk are another aspect of preferences that affect money demand. As we have seen, bonds pay higher interest rates than money deposits, but holding bonds entails a risk that bond prices might fall. There is also a chance that the issuer of a bond will default, that is, will not pay the amount specified on the bond to bondholders; indeed, bond issuers may end up paying nothing at all. A money deposit, such as a savings deposit, might earn a lower yield, but it is a safe yield.
Heightened concerns about risk in the last half of led many households to increase their demand for money. Such an increase could result from a higher real GDP, a higher price level, a change in expectations, an increase in transfer costs, or a change in preferences.
The reverse of any such events would reduce the quantity of money demanded at every interest rate, shifting the demand curve to the left. The Supply of Money The supply curve of money Curve that shows the relationship between the quantity of money supplied and the market interest rate, all other determinants of supply unchanged.
We have learned that the Fed, through its open-market operations, determines the total quantity of reserves in the banking system. We shall assume that banks increase the money supply in fixed proportion to their reserves. Because the quantity of reserves is determined by Federal Reserve policy, we draw the supply curve of money in Figure In drawing the supply curve of money as a vertical line, we are assuming the money supply does not depend on the interest rate.
Changing the quantity of reserves and hence the money supply is an example of monetary policy. The supply curve of money is a vertical line at that quantity.
Equilibrium in the Market for Money The money market The interaction among institutions through which money is supplied to individuals, firms, and other institutions that demand money.
Aggregate demand and aggregate supply curves
Money market equilibrium The interest rate at which the quantity of money demanded is equal to the quantity of money supplied. With a stock of money Mthe equilibrium interest rate is r. Here, equilibrium occurs at interest rate r. Effects of Changes in the Money Market A shift in money demand or supply will lead to a change in the equilibrium interest rate. Changes in Money Demand Suppose that the money market is initially in equilibrium at r1 with supply curve S and a demand curve D1 as shown in Panel a of Figure Now suppose that there is a decrease in money demand, all other things unchanged.
A decrease in money demand could result from a decrease in the cost of transferring between money and nonmoney deposits, from a change in expectations, or from a change in preferences. In this chapter we are looking only at changes that originate in financial markets to see their impact on aggregate demand and aggregate supply.
Changes in the price level and in real GDP also shift the money demand curve, but these changes are the result of changes in aggregate demand or aggregate supply and are considered in more advanced courses in macroeconomics. Panel a shows that the money demand curve shifts to the left to D2. We can see that the interest rate will fall to r2.
To see why the interest rate falls, we recall that if people want to hold less money, then they will want to hold more bonds. Thus, Panel b shows that the demand for bonds increases. The higher price of bonds means lower interest rates; lower interest rates restore equilibrium in the money market. The fall in the interest rate will cause a rightward shift in the aggregate demand curve from AD1 to AD2, as shown in Panel c.
As a result, real GDP and the price level rise. Lower interest rates in turn increase the quantity of investment. They also stimulate net exports, as lower interest rates lead to a lower exchange rate. An increase in money demand due to a change in expectations, preferences, or transactions costs that make people want to hold more money at each interest rate will have the opposite effect. The money demand curve will shift to the right and the demand for bonds will shift to the left.
The resulting higher interest rate will lead to a lower quantity of investment. Also, higher interest rates will lead to a higher exchange rate and depress net exports. Thus, the aggregate demand curve will shift to the left. All other things unchanged, real GDP and the price level will fall. Changes in the Money Supply Now suppose the market for money is in equilibrium and the Fed changes the money supply.
All other things unchanged, how will this change in the money supply affect the equilibrium interest rate and aggregate demand, real GDP, and the price level? Suppose the Fed conducts open-market operations in which it buys bonds.