Chapter 34

Chapter 34 discusses the effect of fiscal and monetary policies on the aggregate demand of an economy. Keynes developed a theory for the short run fluctuations called the the theory of liquidity. This theory explains how interest rates are determined. The interest rates adjust in order for the supply and demand for money to be in an equilibrium. When the price level increases, the money demanded increases due to dollar depreciation and interest rates rise. The higher the interest rate, the  less investment and vice versa. The downward slope of the aggregate demand shows the negative correlation between the price level and the quantity of money demanded.  Policymakers influence the aggregate demand by making monetary policies. These policies cause fluctuations in monetary value. When the money supply is increased, the interest rate equilibrium decreases. This decrease in interest rate shifts the aggregate demand curve to the right.  Decrease in money supply shifts the aggregate demand curve to the left. Fiscal policies can also effect the aggregate demand of an economy. When there is an increase in government purchases or a cut in taxes, the aggregate demand curve shifts right. A decrease in government purchases or increased taxes shift the aggregate demand curve to the left. When the government changes either spending or taxes, the shift in the aggregate demand caused by this can be either smaller or larger than the fiscal change. However, the crowding out effect usually dampens the effect of fiscal policies on demand.