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Money & Banking ­ MGT411
VU
Lesson 42
THE AGGREGATE DEMAND CURVE
The slope of the aggregate demand curve tells us how sensitive current output is to a given
change in current inflation.
The aggregate demand curve will be relatively
Flat if current output is very sensitive to inflation (a change in current inflation causes a large
movement in current output)
Steep if current output is not very sensitive to inflation
Three factors influence the sensitivity of current output to inflation:
The strength of the effect of inflation on real money balances,
The extent to which monetary policymakers react to a change in current inflation,
The size of the response of aggregate demand to changes in the interest rate
The second factor relates to the slope of the monetary policy reaction curve
If policymakers react aggressively to a movement of current inflation away from its target level
with a large change in the real interest rate, the monetary policy reaction curve will be steep and
the aggregate demand curve is flat
If policymakers respond more cautiously, the monetary policy reaction curve is flat and the
aggregate demand curve is steep
The slope of the aggregate demand curve depends in part on the preferences of the central bank;
how aggressive policymakers are in responding to deviations of inflation from the target level
There are two reasons why the aggregate demand curve slopes down:
First, because higher inflation reduces real money balances (thus reducing purchases),
Second, because higher inflation induces policymakers to raise the real interest rate, depressing
various components of aggregate demand
Rising inflation also reduces wealth, which lowers consumption and drives down aggregate
demand.
In addition, as inflation rises the uncertainty about inflation rises, which makes equities a more
risky investment and drops their value, also reducing wealth
Another reason is that inflation can have a greater impact on the poor than it does on the
wealthy, redistributing income to those who are better off
People may also save more as a result of the increased risk associated with inflation.
Also, rising inflation makes foreign goods cheaper in relation to domestic goods, driving
imports up and net exports down.
Shifting the Aggregate Demand Curve
In our derivation of the aggregate demand curve, we held constant both the location of the
monetary policy reaction curve and those components of aggregate demand that do not respond
to the real interest rate.
Changes in any of those components, as well as changes in the location of the monetary policy
reaction curve, will shift the aggregate demand curve.
Shifts in the Monetary Policy Reaction Curve
Whenever the monetary policy reaction curve shifts, the aggregate demand curve will shift as
well
Changes in the long-run real interest rate, which is a consequence of the structure of the
economy, will also shift aggregate demand
133
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Money & Banking ­ MGT411
VU
Figure: Shifting the Aggregate Demand Curve (ADC)
Increases in aggregate Demand arising from a change in monetary policy, such as a higher
inflation target, will shift the aggregate demand curve to the right. Increases in interest rate
intensive components of aggregate demand, such as government purchases, will also shift the
aggregate demand curve to the right.
Inflation ()
New ADC
Old ADC
Output (Y)
Either a fall in target inflation or a rise in the long-run real interest rate will shift the monetary
policy reaction curve to the left and the aggregate demand curve to the left.
Changes in the Components of Aggregate Demand
Any change in a component of aggregate demand that is caused by a factor other than a change
in the real interest rate will shift the aggregate demand curve.
When firms become more optimistic about the future, or consumer confidence increases,
investment or consumption will increase and aggregate demand will shift to the right.
Changes in the Components of Aggregate Demand
Increases in government purchases will increase aggregate demand, as will decreases in taxes.
Increases in net exports that are unrelated to changes in real interest rates will shift the
aggregate demand curve to the right
Changes that shift the Components of Aggregate Demand to the right:
An increase in consumption that is unrelated to a change in the real interest rate.
An increase in investment that is unrelated to a change in the real interest rate.
An increase in government purchases
A decrease in taxes
An increase in net exports that is unrelated to a change in the real interest rate
Because shifts in the monetary policy reaction curve can shift the aggregate demand curve, it is
possible that monetary policy can cause recessions.
If policymakers can cause recessions, they can probably avoid them as well by neutralizing
shifts in aggregate demand that arise from other sources.
The analysis up to this point has assumed that inflation does not change over time; but in reality
Inflation and output are jointly determined, and monetary policy plays a role in the short-run
Movements of both.
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY