Monetary Policy and Aggregate Demand - Video Tutorials & Practice Problems
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Monetary Policy and Aggregate Demand
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Alright, now, let's see the relationship of monetary policy with our aggregate demand curve. So we're gonna be analyzing these two graphs together, money market and aggregate demand. Okay, so remember when we discussed aggregate demand, it's basically the total spending in an economy, right? This total spending, which we defined as consumption plus investment spending plus government purchases plus net exports. Okay, so the interest rate is going to affect aggregate demand because it affects consumption, it affects investment and it affects net exports. So a change in the interest rate is going to shift our aggregate demand curve to the left or to the right, Okay, so let's go ahead and think about this in a little detail of how the interest rate affects consumption, investment and net exports were gonna leave government purchases out of this for now that we deal with that more when we talk about fiscal policy and what the government does. So in this case, let's think about how the interest rate affects uh these three components. So first consumption. So let's think about the interest rate, if consumption being the consumer's purchasing things in general. So you and me buying stuff. So are we going to buy more stuff if there's higher interest rates or lower interest rates, we'll buy more stuff at lower interest rates. Right? So if you can get a car loan, that's a very low interest rate on a car or um on any sort of big purchase, you're gonna buy some appliances in your house, whatever it might be, um if you get a really good low rate, you might be willing to spend a little more, right? Because the interest rates are low. Another reason is because of saving not being that enticing, right? So at very low interest rates were not enticed to save because we're not gonna get that much interest. So if we're not saving, we're gonna be consuming generally instead. Okay, so consumption increases. So interest rate is low consumption goes up, right. Lower interest rates lead to higher consumption about investment. Now, think about investment. If if uh companies are going to purchase uh new equipment, purchase buildings, they're gonna need to take out loans, Do you think they're gonna want to take those loans out at a high interest rate or low interest rate? A low interest rate, right? The lower the interest rate, you're gonna pay less interest on the loan, less interest expense. So if the interest rate is low, we see investment go up, right, Investment is going to be higher because the lower interest costs that you have finally net exports. So this one's a little more detailed, but we lead to the same conclusion. So when we think about exports, if the interest rates fall in the US, well then foreigners are gonna demand less dollars, right? The same reason consumers in the U. S. Would demand less dollars. Well. So would um So would foreigners as well, there would just be a lower demand for the U. S. Dollars. And if there's lower demand for the U. S. Dollars, the dollar value is weakened. And how does that affect net exports? Well, if there's a weaker dollar, there's gonna be less imports, right? We have less money to buy foreign goods. The foreign goods are more expensive relative to our domestic goods. Because we have weaker currency. The weaker currency is it's gonna be more expensive to buy imports. So remember that import net exports is equal to exports minus imports. So if there's gonna be less imports, if imports go down, we're subtracting a smaller number leading to higher net exports. Okay. So net exports is tricky because there's this exports minus imports going on inside of it. But you don't have to get too detailed into it. Just knowing that the interest rate going down has that same effect that net exports go up as well. So a lower interest rate is going to affect consumption, uh investment and exports all in the same way they're all gonna increase at lower interest rates. Okay, so exports also let's fill this in increase. So how is this important? Well, once once we start analyzing money market and aggregate demand, we're gonna analyze these two graphs together. One thing we have to note is that the interest rate is the y. Axis on the money market graph. Right? We saw that the cost of money, the price of money is the interest rate, but it's not part of the graph on the aggregate demand curve. It's a factor that shifts the aggregate demand curve left or right, just like we saw here when interest rates go down well, these all three of these go up. So at lower interest rates were shifting to the right. Okay, so let's pause here and let's go through some examples and analyze the graphs of the money market and aggregate demand.
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Interest Rates and Aggregate Demand
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6m
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Alright, So let's go through this example together. And let's see how the relationship between the money market and our interest rates affect the aggregate demand curve. So in this idea, in this example, we're gonna have the Fed intends to stimulate the economy by lowering interest rates. They want lower interest rates. That's going to incentivize businesses to invest by having lower interest rates for their loans, right? It's gonna incentivize consumption just like we discussed above. So first question, what open market operation should the Fed use to lower the interest rates? So let's think about our money market, right? And the Fed wants to lower interest rates. Well, let's see what we've got here. Remember that our why access is the interest rate in the market, right? The price of money being the interest rate and the quantity of money is fixed by the Fed right? The quantity of money available right here at our first equilibrium was fixed by the Fed at Q1. And we had this equilibrium interest rate, we'll say our one was our original equilibrium interest rate. Alright, so just looking at the graph, do you think, remember that the Fed is going to affect the money supply? They're either going to increase or decrease the money supply uh to find a lower equilibrium interest rate. So what do you think? Do you think that the Fed wants to increase the money supply or decrease the money supply? So try and visualize on this graph where the where the new equilibrium would be if we increase the money supply or the new equilibrium if we decrease the money supply. So the Fed would want to increase the money supply to decrease? Excuse me, decrease the equilibrium interest rate? Right? They want a lower interest rate. So by increasing the money supply. So let's draw a new money supply out here. Yeah. Which is increased, right? They've increased the quantity of money available to Q2. So at Q. two. What's our equilibrium interest rate? It's lower right. We see that there's a new point where they cross down here and we have a lower equilibrium interest rate, right? It's lower than it was before. So what did we see in this in this case? Is that by increasing the money supply, the equilibrium interest rate decreases. Okay. And that's exactly what the Fed wants to do in this example is lower, have lower interest rates. So by increasing the money supply, that's gonna happen. So how do they increase the money supply? What open market operation do they go through? Remember that the open market operations? Is that the Fed can either purchase securities or sell securities if they want to increase the money supply, that means they want to put more hands more money in the hands of the public. So how are they gonna do gonna do that? Let's think about an open market operation. I like to draw this little diagram with the Fed and the public and we're going to have something going from the Fed to the public and something going from the public to the Fed in this transaction. So what is the Fed going to give to the public? Does the Fed want to increase or decrease the money supply? They want to increase it. Right? So they want to give money to the public. So we're gonna see dollars going to the public. Money is going to the public. And what's coming from the public to the Fed is those securities, right? The Treasury securities that they're buying from the public and the money is going to the public. So, did the Fed go through an open market purchase or an open market sale? They did a purchase, right? The Fed purchased securities. So the answer to part A let me do it up in this corner. A the answer is a purchase securities from public. Right? That is the open market operation that the Fed is going to go through here is to purchase securities from the public. And that will lead us to have a higher money supply and a lower equilibrium interest rate. So, now, let's think about question B. What effect will the lower interest rate have on aggregate demand? So, let's think about what we talked about above. Remember that aggregate demand, uh, is, is composed of consumption, investment, government purchases net exports. Right. And we we already discussed how lower interest rate is going to increase our consumption, increase our investment, increase our net exports. Right? So, we would have some sort of chain effect like this, we would have interest rates go down, leading to higher consumption, higher investment, higher net exports, all of these things are going up which in turn leads to higher aggregate demand. Right? All of the components of aggregate demand are increasing, leading to higher aggregate demand. So on our aggregate demand curve we had the price level, so the general price level in the economy on the Y axis and we had GDP. So the G. D. P. Were demanding in this case, how much production are we demanding in this case, on our uh X. Axis there? So at a lower interest rate, what do we see Is a new aggregate demand curve to the right. So the aggregate demand curve would shift to the right from A. D. one 2, 8 d. two. Okay. And this would have all sorts of implications on the aggregate demand, aggregate supply and the new equilibrium of of our the new equilibrium in our A. D. A. S. Model as well. Okay. But just for now it's good to know that this effect in the money market so by by affecting the money market through this increase in the money supply, it's going to affect our aggregate demand, right? Because that lower interest rate is gonna increase aggregate demand. So this is a useful thing that the Fed might do during a recession, right? We've learned that during recessions it's generally due to a lack of spending right? There's not enough spending going on in the economy and everything is kind of slowing down. And we we see the economy diving into a recession. So something the the Fed can do is go through a open market purchase of securities to increase the money supply, which decreases the equilibrium interest rate, and that decreased equilibrium interest rate incentivizes more spending from from all three consumption investment and exports there. Okay, so let's pause here and let's talk about one more relationship between these two graph.
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Price Levels and the Money Market
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6m
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Alright. So now let's see how the price level affects both the money market and the aggregate demand curve. So remember when we studied um the aggregate demand curve, the price level is the Y axis right? On aggregate demand curve we have price level here on the y axis and we have G. D. P. On this axis. Right. And what about in our money market? So our X axis was GDP there. What about in our money market are money market? We had the interest rate as the price of money over here and the quantity of money uh was down there and remember that the quantity is fixed by the Fed, right? If the Fed says how much money there is in the market, that's fixed by how much they supply there. So here we have our aggregate demand curve, we'll say a D. One, we've got our money supply and we've got our money demand here as well. Right. So those are all of the curves that we're dealing with. So now let's go through an example and let's see how a change in the price level is gonna affect these two graphs. So the general price level increases in the United States, in the United States. Okay, so we see a general increase, we're going through a period of inflation here. What effect will this have on the following graphs? So let's start with our aggregate demand curve, let's think about how it affects aggregate demand, remember that the price level is our Y axis. So since price level is a component of the graph, it's our Y axis. Just like with any graph? If if the if the Y axis is what's changing? So if the interest rate changes well then we're not going to um move, shift the curve we're gonna move along the curves. But if the interest rate changes over here well that's not part of the graph. Right? So that could shift the curves here. We have the price level. So if the price level changes we're not going to draw a new aggregate demand curve. We're gonna move along the aggregate demand curve. Just like we've studied when the price of the of the object changes we're gonna move along the curve when an underlying factor changes. That's when we shift the curves. So in the aggregate demand graph um we're gonna see that the price level changing is just gonna move us along this aggregate demand curve. So let's say we started at this price level here we'll say P. Low the low price. Well we would have been demanding this much GDP right this would have been the G. D. P. one. Right? The price at the at the low price we would have had um that much g. d. p. But now we're saying price levels increased. So if price levels are increasing to here to a higher price level we'll notice we're not going to draw a new demand curve here we're just gonna find a new point on this demand curve at this lower G. D. P. So what's happening here is there is there is this decrease in G. D. P. When we have a higher price level right? There's a decrease in the G. D. P. Demanded there because the price levels are higher. We're not gonna spend that much as much at that higher price. So if the price level is changing how does that affect our money market? So this is the effect it would have on the on the aggregate demand. Is that the price level would lead to a different point on the aggregate demand curve which has a lower G. D. P. So in the money market well remember that the price level affects one of our curves. Does it affect our money supply or our money demand? So remember when we studied money demand there was the things that shifted the money demand curve and the two most important was the price level and the amount of real GDP in the economy. So if the price level increases. Remember how we discussed about buying a meal at Mcdonald's if you're gonna go to Mcdonald's and there's higher prices. Well you need more cash in your pocket to buy that meal. So if price levels are increasing we're gonna see an increase in the demand for money. So I'm gonna write it over here? Um Price level increase. Money, demand increases. Right? Higher higher prices mean we need more money, we need more cash in this case. So we need to draw a new money demand curve. This will be money demand one, and at a higher price level we need more money. So let's shift to the right and draw a new money demand curve over here. So a new money demand is going to be over here to the right money demand too. So now let's let's look at our equilibrium in this case. So our original equilibrium was right here where the blue lines crossed And we had an equilibrium are one this interest rate R1. But what's happened is we've reached this higher interest rate by the money demand shifting. So now we're at our two, there's a higher demand for money. So interest rates increase because the supply hasn't changed, right? There's the same amount of supply, but there's more demand for that money. So the cost of it is gonna go up through these higher interest rates. Okay, so that's how a change in the price level is gonna affect these two graphs notice in the first situation we affected the interest rate, right? We affected the interest rate, which um by affecting the interest rate in this graph, we only moved along our demand curve. Right? So the the Fed wanted to affect the interest rate, so they increased their supply to move us along the money demand curve. And what did that do? It shifted the aggregate demand, Right? Because its interest rate is not part of this graph, it's an underlying factor of this graph. And down here we shifted the price level, and since we moved the price level, it is part of this graph. So we didn't draw a new curve, we just moved along this curve. And the change in the price level affected the money demand and we didn't move along it. We shifted money demand because of the new price level. Alright, so that's how these two graphs are interrelated. The price level and the interest rate have effects on both of the graphs. Alright, let's go ahead and pause here and move on.
