The Influence of Monetary and Fiscal Policy on Aggregate Demand 34 The Influence of Monetary and Fiscal Policy on Aggregate Demand

Figure 1 Equilibrium in the Money Market Interest Rate Money supply Money demand M d r1 Equilibrium interest rate r2 M2 d Quantity fixed Quantity of by the central bank Money Copyright © 2004 South-Western

Figure 2 The Money Market and the Slope of the Aggregate Demand Curve (a) The Money Market (b) The Aggregate Demand Curve Interest Money Price Rate supply Level Money demand at price level P2 , MD2 2. . . . increases the demand for money . . . r2 Money demand at price level P , MD P2 Y2 3. . . . which increases the equilibrium interest rate . . . 1. An increase in the price level . . . r Y P Aggregate demand Quantity fixed Quantity Quantity 4. . . . which in turn reduces the quantity of goods and services demanded. by the central bank of Money of Output Copyright © 2004 South-Western

Figure 3 A Monetary Injection (a) The Money Market (b) The Aggregate Demand Curve Interest Price Rate Money supply, MS MS2 Level AD2 Money demand at price level P 1. When the central bank increases the money supply . . . r Y P 2. . . . the equilibrium interest rate falls . . . r2 Aggregate demand, A D Quantity Y Quantity 3. . . . which increases the quantity of goods and services demanded at a given price level. of Money of Output Copyright © 2004 South-Western

Figure 4 The Multiplier Effect Price Level AD3 AD2 2. . . . but the multiplier effect can amplify the shift in aggregate demand. Aggregate demand, AD1 £10 billion 1. An increase in government purchases of £10 billion initially increases aggregate demand by £10 billion . . . Quantity of Output Copyright © 2004 South-Western

Figure 5 The Crowding-Out Effect (a) The Money Market (b) The Shift in Aggregate Demand Interest Price 4. . . . which in turn partly offsets the initial increase in aggregate demand. Rate Money AD2 Level supply AD3 2. . . . the increase in spending increases money demand . . . £10 billion M D2 1. When an increase in government purchases increases aggregate demand . . . r2 3. . . . which increases the equilibrium interest rate . . . r Aggregate demand, AD1 Money demand, MD Quantity fixed Quantity Quantity by the central bank of Money of Output Copyright © 2004 South-Western