The Influence of Monetary and Fiscal Policy on Aggregate Demand

Imagine that you are a member of the Federal Open Market Committee, the group at the Federal Reserve that sets monetary policy. You observe that the president and Congress have agreed to cut government spending. How should the Fed respond to this change in fiscal policy? Should it expand the money supply, contract the money supply, or leave the money supply the same? To answer this question, you need to consider the impact of monetary and fiscal policy on the economy. In the preceding chapter, we used the model of aggregate demand and aggregate supply to explain short run economic fluctuations. We saw that shifts in the aggregate-demand curve or the aggregate-supply curve cause fluctuations in the economy’s overall output of goods and services and its overall level of prices. As we noted in the previous chapter, monetary and fiscal policy can each influence aggregate demand. Thus, a change in one of these policies can lead to short-run fluctuations in output and prices. Policymakers will want to anticipate this effect and, perhaps, adjust the other policy in response. In this chapter, we examine in more detail how the government’s policy tools influence the position of the aggregate-demand curve. These tools include monetary policy (the supply of money set by the central bank) and fiscal policy (the levels of government spending and taxation set by the president and Congress). We have previously discussed the long-run effects of these policies. In Chapters 25 and 26, we saw how fiscal policy affects saving, investment, and long-run economic growth. In Chapters 29 and 30, we saw how the Fed controls the money supply and how the money supply affects the price level in the long run. We now see how these policy tools can shift the aggregate-demand curve and, in doing so, affect macroeconomic variables in the short run.
As we have already learned, many factors influence aggregate demand besides monetary and fiscal
policy. In particular, desired spending by households and rums determines the overall demand for goods and services. When desired spending changes, aggregate demand shifts. If policymakers do not respond, such shifts in aggregate demand cause short-run fluctuations in output and employment. As a result, monetary and fiscal policymakers sometimes use the policy levers at their disposal to try to offset these shifts in aggregate demand and thereby stabilize the economy. Here we discuss the theory behind these policy actions and some of the difficulties that arise in using this theory in practice.