Chapter 10

Monetary Policy
and Aggregate
Demand
 Preview

• To understand the positive relationship

between real interest rates and inflation,
which is called the monetary policy (MP)
curve
• To develop the aggregate demand curve
using the monetary policy curve and the
IS curve

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 Planned Expenditure (cont’d)

• Total planned expenditure (aggregate

demand) is:

Y pe  C  I  G  NX
where
C = consumption expenditure
I = planned investment spending
G = government purchases
NX = net exports (exports minus imports)

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 Consumption Expenditure

• Because consumption expenditure is

negatively related to the real interest
rate, r, the consumption function can
be modified as:

C  C  mpc  (Y  T )  cr
where
c = responsiveness of C to r

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 Planned Investment Spending
(cont’d)

• In the investment function, planned

investment is:
– negatively related to the real interest rate
– affected by business expectations about
the future (exogenous), as Keynes called
“animal spirits”

I  I  dr
where
I = autonomous investment
d = responsiveness of investment to the real
interest rate
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 Net Exports

• In the net export function, net export

includes:
– the level of net exports that are exogenous
– a component negatively related to the real
interest rate: A higher real interest rate raises
the demand for dollars and so its exchange rate
(the price of the currency), which in turn lowers
net exports as exports become more expensive
for foreigners
NX  NX  xr
where
NX = autonomous net exports
x = responsiveness of net exports to the real
interest rate

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 Government Purchases and Taxes

• The government affects planned

expenditure through:
– Government purchases: assumed to be
exogenous at G
– Taxes: assumed to be exogenous at T

GG
T T

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 Solving for Goods Market Equilibrium

• The equilibrium condition is:

Y  C  I  G  NX
• Substituting in the consumption, investment and
net export functions so that:
Y = C + mpc ´ (Y - T ) - cr + I - d(r + f ) + G + NX - xr
= C + I + G + NX - mpc ´ T + mpc ´ Y - (c + d + x)r
• The IS curve is obtained by subtracting mpc×Y
from both sides and divide both sides by 1-mpc:
1 cdx
Y  [C  I  G  NX  mpc  T ]   r
1  mpc 1  mpc

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 Understanding the Is Curve
(cont’d)

• What the IS curve tell us: Numerical example

C  $1.1 trillion, I  $1.2 trillion, G  $3.0 trillion

T  $3.0 trillion, NX  $1.3 trillion
mpc  0.6, c  0.1, d  0.2, x  0.1

• What is the IS curve?

1 0.1  0.2  0.1
Y =[1.1  1.2  3.0  1.3  0.6  3.0]   r
1  0.6 1  0.6
4.8 0.4
=   r  12  r
0.4 0.4

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 FIGURE 9.1 The IS Curve

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 The Federal Reserve and
Monetary Policy

• The Fed of the United States conducts

monetary policy by setting the federal funds
rate—the interest rate at which banks lend to
each other
• Because the real interest rate is r  i  e
(Ch. 2), and if prices are sticky, changes in
monetary policy does not immediately affect
inflation and expected inflation
• When the Federal Reserve lowers the federal
funds rate, real interest rates fall; and when
the Federal Reserve raises the federal funds
rate, real interest rates rise.
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 The Monetary Policy Curve

• The monetary policy (MP) curve shows

how monetary policy, measured by the real
interest rate, reacts to the inflation rate,  :
r  r  
where
r  autonomous component of r
  responsiveness of r to inflation

• The MP curve is upward sloping: real interest

rates rise when the inflation rate rises

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 FIGURE 10.1 The Monetary Policy
Curve

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 The Taylor Principle: Why the Monetary
Policy Curve Has an Upward Slope

• The key reason for an upward sloping MP

curve is that central banks seek to keep
inflation stable
• Taylor principle: To stabilize inflation,
central banks must raise nominal interest
rates by more than any rise in expected
inflation, so that r rises when  rises
• Schematically, if a central bank allows r to
fall when  rises, then:

rounded circle

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 The Taylor Principle: Why the Monetary
Policy Curve Has an Upward Slope

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 Shifts in the MP Curve

• Two types of monetary policy actions that

affect interest rates:
1. Automatic (Taylor principle) changes as
reflected by movements along the MP curve
2. Autonomous changes that shift the MP curve
– Autonomous tightening of monetary policy that
shifts the MP curve upward (in order to reduce
inflation)
– Autonomous easing of monetary policy that
shifts the MP curve downward (in order to stimulate
the economy)

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 FIGURE 10.2 Shifts in the Monetary
Policy Curve

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 Policy and Practice: Movements Along the
MP Curve: The Rise in the Federal Funds
Rate Target, 2004-2006

• Beginning in 2004, the economy was growing

rapidly and inflationary pressure began to rise
• Between June 2004 and June 2006, the FOMC
decided to raise the federal funds rate at every
meeting
• Those actions represented movements along the
MP curve

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 FIGURE 10.3 The Inflation Rate and
the Federal Funds Rate, 2003-2013

Source: Federal Reserve Bank of St. Louis. FRED database. http://research.stlouisfed.org/fred2/categories/118

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 Policy and Practice: Autonomous Monetary
Easing at the Onset of the 2007-2013
Financial Crisis

• When the financial crisis started in August 2007,

inflation was rising and economic growth was
quite strong
• The MP curve would have suggested that the
Fed would continue to keep raising the federal
funds rate
• Instead the Fed lowered the federal funds rate
• This reflects that the Fed pursued autonomous
monetary policy easing, thus shifting the MP
curve down, because the Fed perceived the
economy to weaken in the near future due to
the financial crisis
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 The Aggregate Demand Curve

• The aggregate demand curve represents the

relationship between the inflation rate and
aggregate demand when the goods market
is in equilibrium

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 Deriving the Aggregate Demand
Curve Graphically

• The AD curve is derived from:

– The MP curve
– The IS curve
• The AD curve has a downward slope: As
inflation rises, the real interest rate rises, so
that spending and equilibrium aggregate
output fall

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 FIGURE 10.4 Deriving the AD Curve

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 Box: Deriving the Aggregate Demand
Curve Algebraically

• The numerical version of the AD curve can be derived from (1)

the numerical IS curve from Chapter 9 (Y  12  r ) , and (2)
then substituting in for r from the numerical MP curve
(r  1.0  0.5) :

Y  12  (1.0  0.5)  (12  1)  0.5  11  0.5

• Similarly, the general version of the AD curve can be derived by

substituting in for r from the MP curve (r  r  ) using the
algebraic version of the IS curve in Chapter 9:

1 cdx
Y  [C  I  G  NX  mpc  T ]    (r  )
1  mpc 1  mpc

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 Factors that Shift the Aggregate
Demand Curve

• Shifts in the IS curve

1. Autonomous consumption expenditure
2. Autonomous investment spending
3. Government purchases
4. Taxes
5. Autonomous net exports

• Any factor that shifts the IS curve shifts the

aggregate demand curve in the same
direction

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 FIGURE 10.5 Shift in the AD Curve
From Shifts in the IS Curve

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 Factors that Shift the Aggregate
Demand Curve (cont’d)

• Shifts in the MP curve

– An autonomous tightening of monetary policy,
that is a rise in real interest rate at any given
inflation rate, shifts the aggregate demand
curve to the left
– Similarly, an autonomous easing of monetary
policy shifts the aggregate demand curve to the
right

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 FIGURE 10.6 Shift in the AD Curve From
Autonomous Monetary Policy Tightening

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 The Money Market and Interest
Rates

• The liquidity preference framework

determines the equilibrium nominal
interest rate by equating the supply of and
demand for money
• John Maynard Keynes developed a theory
of money demand that he described as
liquidity preference theory
• Real money balances—the quantity of
money in real terms—reflect how much
money people want to hold (demand)

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 Liquidity Preference and the Demand
for Money

• According to Keynes, the demand for

money can be expressed in the form of the
liquidity preference function:

M d / P  L(i, Y )

where
i = nominal interest rate
Y = nominal income

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 Liquidity Preference and the Demand
for Money (cont’d)

• Why are real money balances negatively

related to i?
– i represents the opportunity cost of holding
money

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 Liquidity Preference and the Demand
for Money (cont’d)

• Why are real money balances positively

related to Y?
– As income rises, households and firms conduct
more transactions and so keep more money on
hand to make purchases
– Higher incomes make households and firms
wealthier, and the wealthy tend to hold larger
quantities of all financial assets, including money

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 Demand Curve for Money

• In short-run analysis, prices are assumed to

be sticky so the price level is fixed at P
• All else being equal, lower real interest rates
mean the opportunity cost of holding money
falls, so that firms and households desire to
higher quantities of real money balances
• As a result, the demand curve for money
slopes downward

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 Supply Curve for Money

• The Fed fixes the money supply by open

market operations
• When the Fed buys (sells) government
securities in open market operations, it
increases (decreases) deposits at banks, so
that bank reserves and liquidity in the
banking system increase (decrease)

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 Supply Curve for Money

• An open market purchase leads to an

increase in liquidity and the money supply
• An open market sale of government
securities leads to a decrease in liquidity
and a decrease in the money supply

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 Supply Curve for Money (cont’d)

• The supply curve for money (MS) shows the

quantity of real money balances supplied at
each price level
• The line MS is a vertical line because:
– The money supply is fixed by the Fed at M
– The price level in the short run is fixed at P
– Thus, the quantity of real money balances
supplied is M s / P  M / P

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 FIGURE 10.7 Equilibrium in the
Money Market

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 Equilibrium in the Money Market

• Equilibrium in the money market occurs

when the quantity of real money balances
demanded equals the quantity of real money
balances supplied:
Md Ms

P P
• Graphically, equilibrium occurs where MD
and MS curves intersect at i*
• An excess supply (demand) of money results
in a decrease (an increase) in i
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 Changes in the Equilibrium Interest
Rate

• A shift in the MD (or MS) curve occurs when

the quantity demanded (or supplied)
changes at each given interest rate in
response to a change in some other factor
besides the interest rate

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 Changes in the Equilibrium Interest
Rate (cont’d)

• Examples of factors that shifts the MD or

MS:
– When income rises, MD shifts to the right and
so interest rates will rise
– When the money supply increases, MS shifts to
the right and so interest rates will decline
– When the price level rises, MS shifts to the
right and so interest rates will rise

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 FIGURE 10.8 Response to Shift in the
Demand Curve from a Rise in Income

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 FIGURE 10.9 Response to Shifts in
the Supply Curve (a)

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 FIGURE 10.9 Response to Shifts in
the Supply Curve (b)

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