Monetary Policy and Aggregate Demand - Online Tutor, Practice Problems & Exam Prep

Monetary policy significantly influences the aggregate demand curve through interest rates, affecting consumption, investment, and net exports. Lower interest rates encourage higher consumption and investment as borrowing costs decrease, while a weaker dollar boosts net exports by making imports more expensive. The Federal Reserve can lower interest rates by increasing the money supply through open market purchases of securities. Conversely, rising price levels lead to increased money demand, resulting in higher interest rates and reduced GDP demanded, illustrating the interconnectedness of the money market and aggregate demand.

Monetary Policy and Aggregate Demand

Alright. Now, let's see the relationship of monetary policy with our aggregate demand curve. So we're going to 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. We're going to 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 these three components.

So first, consumption. Let's think about the interest rate. If consumption being the consumers purchasing things in general is the case, 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? If you can get a car loan that's a very low interest rate on a car or on any sort of big purchase, you're going to buy some appliances in your house, whatever it might be. 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? At very low interest rates, we're not enticed to save because we're not going to get that much interest. So if we're not saving, we're going to be consuming generally instead. Okay? So consumption increases. So interest rate is low, consumption goes up. Right? Lower interest rates lead to higher consumption.

How about investment? Now, think about investment. If companies are going to purchase new equipment, purchase buildings, they're going to need to take out loans. Do you think they're going to want to take those loans out at a high interest rate or a low interest rate? A low interest rate, right? The lower the interest rate, you're going to 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 of the lower interest costs that you have.

Finally, net exports. 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 going to demand fewer dollars. Right? The same reason consumers in the US would demand fewer dollars. Well, so would foreigners as well. There would just be a lower demand for the US dollars. And if there's lower demand for the US dollars, the dollar value is weakened. And how does that affect net exports? Well, if there's a weaker dollar, there's going to be fewer imports, right? We have less money to buy foreign goods. The foreign goods are more expensive relative to our domestic goods because we have a weaker currency. The weaker currency is going to be more expensive to buy imports. So remember that net exports is equal to exports minus imports. So if there are going to be fewer imports, we're subtracting a smaller number, leading to higher net exports. Okay? So net exports are 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, investment, and net exports all in the same way. They're all going to increase at lower interest rates. Okay? So net exports also, let's fill this in, increase.

So how is this important? Well, once we start analyzing money market and aggregate demand, we're going to 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, we're 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.

Interest Rates and Aggregate Demand

Alright. So let's go through this example together and see how the relationship between the money market and our interest rates affect the aggregate demand curve. In this example, the Fed intends to stimulate the economy by lowering interest rates. Lower interest rates are going to incentivize businesses to invest by providing lower interest rates for their loans, right? It's going to incentivize consumption, just like we discussed above. So the first question is: what open market operation should the Fed use to lower the interest rates? Let's think about our money market, right? The Fed wants to lower interest rates. Remember that our y-axis represents the interest rate in the market, the price of money being the interest rate, and the quantity of money is fixed by the Fed. Initially, the quantity of money available at our first equilibrium was fixed by the Fed at Q₁, and we had this equilibrium interest rate, which we'll say R₁ was our original equilibrium interest rate.

Just looking at the graph, remember that the Fed is going to affect the money supply. They're either going to increase or decrease the money supply 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? Try to visualize on this graph where the new equilibrium would be if we increase the money supply, or the new equilibrium if we decrease the money supply. The Fed would want to increase the money supply to decrease the equilibrium interest rate. They want a lower interest rate. So, by increasing the money supply, let's draw a new money supply curve here which is increased. They've increased the quantity of money available to Q₂. So at Q₂, what's our equilibrium interest rate? It's lower. We see that there's a new point where they intersect down here, and we have a lower equilibrium interest rate.

In this case, by increasing the money supply, the equilibrium interest rate decreases. That's exactly what the Fed wants to do in this example: lower interest rates. So how do they increase the money supply? What open market operation do they go through? Remember that the open market operations mean 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 money in the hands of the public. So, let's think about an open market operation. I like to draw this little diagram with the Fed and the public. 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. What is the Fed going to give to the public? The Fed wants to increase the money supply, right? So they want to give money to the public. We're going to see dollars going to the public, and what's coming from the public to the Fed are the treasury securities that they're buying from the public. The money is going to the public.

Did the Fed go through an open market purchase or an open market sale? They did a purchase. The Fed purchased securities. So the answer to part a is: purchase securities from the public. That is the open market operation the Fed is going to go through here to have a higher money supply and a lower equilibrium interest rate. Now, let's think about question b. What effect will the lower interest rate have on aggregate demand? Remember that aggregate demand is composed of consumption, investment, government purchases, and net exports. We already discussed how a lower interest rate is going to increase our consumption, investment, and net exports. So we would have some sort of chain effect like this: a lower interest rate leading to higher consumption, investment, and net exports. All of these components are going up, which in turn leads to higher aggregate demand.

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 at a lower interest rate, what do we see? A new aggregate demand curve shifted to the right from AD₁ to AD₂. This would have all sorts of implications on the aggregate demand, aggregate supply, and the new equilibrium in our AD-AS model as well. But just for now, it's good to know that this effect in the money market, by affecting the money market through this increase in the money supply, is going to affect our aggregate demand because that lower interest rate is going to increase aggregate demand. This is a useful mechanism that the Fed might use during a recession. We've learned that during recessions, it's generally due to a lack of spending. There's not enough spending going on in the economy, and everything's kind of slowing down, leading the economy into a recession. So, something the Fed can do is go through an 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 consumption, investment, and net exports. Okay? So let's pause here and talk about one more relationship between these two graphs.

Price Levels and the Money Market

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 the aggregate demand curve, the price level is the y-axis. Right? On the aggregate demand curve, we have the price level here on the y-axis and we have GDP on this axis, right? And what about in our money market? So our x-axis was GDP there. What about in our money market? Our money market, we had the interest rate as the price of money over here and the quantity of money, 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 at AD1. 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 going to affect these two graphs. So the general price level increases in the United States. Okay. So we see a general increase. We're going through a period of inflation here. What effects 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 the y-axis is what's changing, so if the interest rate changes, well, then we're not going to 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 gonna 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 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, 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 GDP₁. Right? The price at the, at the low price, we would have had, that much GDP. But now we're saying price levels increased. So if price levels are increasing to here to a higher price level, well, notice, we're not going to draw a new demand curve here. We're just going to find a new point on this demand curve at this lower GDP. So what's happening here? Is there a is a decrease in GDP when we have a higher price level, right? There's a decrease in in the GDP 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 aggregate demand is that the price level would lead to a different point on the aggregate demand curve which has a lower GDP. 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 2 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 going to 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 going to write it over here. 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 1. 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 our new money demand is gonna be over here to the right, money demand 2. 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 r₁, 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 r₂. 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 going to 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 by affecting the interest rate in this graph, we only moved along our demand curve, right? So the Fed wanted to affect the interest rate, so they increase their supply to move us along the money demand curve. And what did that do? It shifted the aggregate demand, right? Because 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 move 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 the money demand because of the new price level. Alright? So that's how these 2 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.

Here’s what students ask on this topic:

How does monetary policy affect aggregate demand?

Monetary policy affects aggregate demand primarily through changes in interest rates. When the Federal Reserve lowers interest rates, borrowing costs decrease, which encourages higher consumption and investment. Lower interest rates also weaken the dollar, making imports more expensive and boosting net exports. Conversely, higher interest rates increase borrowing costs, reduce consumption and investment, and strengthen the dollar, leading to lower net exports. These changes shift the aggregate demand curve to the right (increase) or left (decrease), impacting overall economic activity.

What is the relationship between interest rates and aggregate demand?

The relationship between interest rates and aggregate demand is inverse. Lower interest rates reduce the cost of borrowing, which increases consumption and investment. Additionally, a weaker dollar from lower interest rates makes imports more expensive and exports cheaper, boosting net exports. This results in a rightward shift of the aggregate demand curve. Conversely, higher interest rates increase borrowing costs, reduce consumption and investment, and strengthen the dollar, leading to lower net exports and a leftward shift of the aggregate demand curve.

How do open market operations influence interest rates and aggregate demand?

Open market operations involve the Federal Reserve buying or selling government securities to influence the money supply. When the Fed purchases securities, it increases the money supply, which lowers interest rates. Lower interest rates reduce borrowing costs, leading to higher consumption and investment, and a weaker dollar, which boosts net exports. This increases aggregate demand, shifting the curve to the right. Conversely, selling securities decreases the money supply, raises interest rates, reduces consumption and investment, strengthens the dollar, and lowers net exports, shifting aggregate demand to the left.

What happens to aggregate demand when the Federal Reserve increases the money supply?

When the Federal Reserve increases the money supply, it typically lowers interest rates. Lower interest rates reduce borrowing costs, encouraging higher consumption and investment. Additionally, a weaker dollar from lower interest rates makes imports more expensive and exports cheaper, boosting net exports. These factors collectively increase aggregate demand, shifting the aggregate demand curve to the right. This is a common strategy used by the Fed to stimulate economic activity during periods of recession or economic slowdown.

How do changes in the price level affect the money market and aggregate demand?

Changes in the price level affect both the money market and aggregate demand. An increase in the price level raises the demand for money, shifting the money demand curve to the right and increasing interest rates. Higher interest rates reduce consumption and investment, and strengthen the dollar, leading to lower net exports. This results in a movement along the aggregate demand curve to a lower GDP demanded. Conversely, a decrease in the price level reduces money demand, lowers interest rates, and increases aggregate demand, shifting the curve to the right.