Chapter 34

Chapter 34 discusses the effect of monetary and fiscal policies on the aggregate demand/supply curves. Discussing why the aggregate demand is downward sloping, being the wealth, interest, and real exchange effect. The interest is a key determinant of aggregate demand. We use the theory of liquidity preference to show how interest rates affect aggregate supply and demand. In the book it refers that we are determining are both nominal and real since since in the short run, expected inflation is unchanging so changes in the nominal equal real interest rates. The interest rate is the opportunity cost of money. When interest rates are high, people like to hold their money and economize it through bonds thus aggregate demand is reduced. Monetary policies target changing the interest rates or the money supply thus shifting the aggregate demand.
Fiscal policy refers to the government’s choices on the levels of government purchases and taxes. While fiscal policy can influence growth in the long run, its primary impact in the short run is on aggregate demand. When the government changes their level of government purchases of taxes, two outcomes can come into play: the multiplier effect and the crowding out effect. In the multiplier effect for example, the government purchases $20 billion worth of aircrafts. The incomes, wages, and profits rise in the aircraft manufacturers allowing the them to increase on consumption goods which raises the incomes of other firms. Since aggregate demand shifts right and may rise more than the government purchases, these government purchases are said to have the multiplier effect. The crowding out effect is the exact opposite of the multiplier effect. An increase in government purchases (as in the case above) raises incomes, which shifts the demand for money to the right. This raises the interest rate, which lowers investment. Thus, an increase in government purchases increases the interest rate and reduces, or crowds out, private investment. Due to crowding out, the aggregate-demand curve may shift right by less than the increase in government purchases.
Level of difficulty 2/3.