The effect of monetary and fiscal policy on aggregate demand
Monetary policy and Aggregate demand
Monetary policy: A government's or central bank's policy for control of the amount of currency available and the rate at which people can borrow money
Expansionary Monetary Policy
Expansionary monetary policy tries to expand the economy, i.e. increase the real output (Y), by channeling more saving into investment
For real output to be increased, aggregate demand has to be increased. For the consumption to be increased, the public needs an incentice to invest or a disincentive to save. The monetary policy allows for a disincentive to be created.
The monetary policy deals with the interest rates in the economy, to increase aggregate demand; money supply has to be increased. This is done by decreasing the interest rates (i) in the economy and thus increasing the money supply (M) in the economy.
As interest rates fall, people will see more benefit in investing and so they will withdraw their savings and instead invest it in more porfitable areas, areas that will provide greater returns. Also as the interest rates fall, the borrowing in the economy will tend to increase, this would cause consumption to increase as people will have more money to spend.
As shown in the graph below, the aggregate demand will increase from AD0 to AD1 if interest rates are decreased. Investment (I) will increase and so will Real output (Y). The only thing that will need to be controlled in the long run is the price, as can be seen from the graph the price rises from P0 to P1, if the interest rates are decreased by a large amount, the increase in price will be large as well and in the long run consumption would fall due to the fall in the purchasing power of the money, thus saving would increase and their could be an equilibrium between saving and investment in the long run.
Thus it can be concluded that an expansionary policy helps increase Real Output (GDP) and investment in the...