Aggregate Demand Policies

Both fiscal and monetary policy changes shift the AD curve. Let us see how, starting with a fiscal expansion. See figure 6.2. In the upper panel, the initial LM and IS schedules correspond to a given nominal quantity of money and the price level P⁰. The equilibrium is at point E and there is a corresponding point on the AD schedule in the lower panel. When there is a fiscal expansion, the IS schedule shifts outward and to the right. At the initial price level there is a new equilibrium at point E^lwith higher interest rates and higher level of income - and spending. Thus at the initial level of prices, P⁰, equilibrium income and spending are now higher. This is shown by plotting point E^l in the lower panel. Point E^l is a point on the new aggregate demand curve AD^l. Doing a similar exercise at other points on the original AD leads us to the derivation of the new aggregate demand curve AD^l. We see that the aggregate demand curve has shifted to the right because of fiscal expansion. A fiscal contraction produces the opposite result.

Figure 1

Now, let us study the effect of change in monetary policy on the aggregate demand curve. See figure 6.3. An increase in the nominal stock of money implies a higher real money stock at each level of prices and thus shifts the LM curve to LM^l in the upper panel.

The equilibrium level of income rises from Y⁰ to Y^l at the initial price level, P⁰. Correspondingly, the AD curve moves out to the right, to AD^l, with point E^l in the lower panel corresponding to E^l in the upper panel. The AD curve shifts up in exactly the same proportion as the increase in the money stock. For instance, at point K the price level, P^l, is higher than P⁰ in the same proportion that the money supply has increased. Real balances at K and AD^l are therefore the same as at E on AD.

Figure 2