CHANGES IN THE MONEY SUPPLY
So far, we have used the theory of liquidity preference to explain more fully how the total quantity demanded of goods and services in the economy changes as the price level changes. That is, we have examined movements along the downward-sloping aggregate-demand curve. The theory also sheds light, however, on some of the other events that alter the quantity of goods and services demanded. When ever One important variable that shifts the aggregate-demand curve 1 monetary policy. To see how monetary policy affects the economy in the short run, suppose that the Fed increases the money supply by buying government bonds in open-market operations. the Fed do this will become clear later, after we the effects of such a move.) Let’s consider how nus monetary injection influences the equilibrium interest rate for a given price level This will tell us what the injection does to the position of the aggregate-demand curve. As panel (a) of Figure 3 shows, an Increase in me money SUPPLY shifts the money-supply curve to the tight from MS) to MS2· Because the money-demand curve has not Changed, the interest rate falls from 1″1 to I’~ to balance money supply and money demand That is, the interest rate must fall to induce people to hold the additional money the Fed has created
A Monetary Injection
Once agar, the interest rate influences the quantity of goods and services demanded, as shown ,u panel (b) of Figure 3. The lower interest rate reduces the cost of borrowing and the return to saving Hoist holds buy more and larger houses, stimulating the demand for residential investment. Firms spend more on new factories and new equipment, stimulating business investment. As a result, the quantity of goods . services demanded at a given price level, ]5, rises from Y1 to Y2• Of course, there is nothing special about P: The monetary injection raises the quantity of goods and services demanded at every price level. Thus, the entire aggregate-demand curve shifts to the right.