Page 729 - The Principle of Economics

CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 749
Interest Rate
r2
r1
(a) The Money Market
Figure 32-5
THE CROWDING-OUT EFFECT. Panel (a) shows the money market. When the government increases its purchases of goods and services, the resulting increase in income raises the demand for money from MD1
to MD2, and this causes the equilibrium interest rate to rise from r1 to r2. Panel (b) shows the effects on aggregate demand. The initial impact of the increase in government purchases shifts the aggregate-demand curve from AD1 to AD2. Yet, because the interest rate is the cost of borrowing, the increase in the interest rate tends to reduce
the quantity of goods and services demanded, particularly for investment goods. This crowding out of investment partially offsets the impact of the fiscal expansion on aggregate demand. In the end, the aggregate-demand curve shifts only to AD3.
Money supply
2. . . . the increase in spending increases money demand . . .
MD2
Money demand, MD1
3. . . . which increases the equilibrium interest
rate . . .
Price Level
0 Quantity fixed by the Fed
Quantity of Money
(b) The Shift in Aggregate Demand
1. When an increase in government purchases increases aggregate demand . . .
$20 billion
4. . . . which in turn partly offsets the initial increase in aggregate demand.
AD2 AD3
Aggregate demand, AD1
0
Quantity of Output
interest rates make borrowing more costly, which reduces investment spending. This is the crowding-out effect. Depending on the size of the multiplier and crowding-out effects, the shift in aggregate demand could be larger or smaller than the tax change that causes it.
In addition to the multiplier and crowding-out effects, there is another impor- tant determinant of the size of the shift in aggregate demand that results from a tax change: households’ perceptions about whether the tax change is permanent or temporary. For example, suppose that the government announces a tax cut of $1,000 per household. In deciding how much of this $1,000 to spend, households must ask themselves how long this extra income will last. If households expect the