Monetary policy and aggregate demand
How the central bank moves interest rates and aggregate demand in the short run, using Keynes's theory of liquidity preference.
FinanceThe economy behind your investmentsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Explain the theory of liquidity preference
- Show how a change in the money supply shifts aggregate demand
- Explain why central banks target an interest rate
Builds toward: Invest on your own. Understand low-cost funds, read a fund factsheet, and spot a sales pitch.
The economy behind your investments: lesson 6 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 21
What it is
Earlier lessons set the interest rate in the market for loanable funds, a long-run view. For the short run, Mankiw uses Keynes's theory of liquidity preference: the interest rate adjusts to balance the supply of and demand for money.
- Money supply: set by the central bank, so it doesn't depend on the interest rate: a vertical line.
- Money demand: people hold money because it is the medium of exchange, even though it pays little or no interest. The interest rate is the opportunity cost of holding money: when it rises, people hold less money and more interest-bearing bonds. So money demand slopes downwards.
- Equilibrium: the interest rate at which people want to hold exactly the money the central bank has supplied.
(Mankiw notes that the two theories don't conflict: in the long run the interest rate is set in the loanable-funds market; in the short run, with prices sticky, it moves to balance the money market.)
Quick check
Tap an answer to check it.
Interest rates rise. What happens to the quantity of money people want to hold?
- Higher interest makes bonds more attractive than money
Show answer
It falls: holding money costs more in lost interest. The interest rate is the opportunity cost of holding money.
Why it matters
Why aggregate demand slopes down (again). A higher price level means people need more money for purchases, so money demand rises, pushing the interest rate up. A higher interest rate cuts investment (and other interest-sensitive spending), so the quantity of goods demanded falls. Mankiw notes this interest-rate effect is the most important of the three reasons in the US: the wealth effect is small because money is a small part of wealth, and the exchange-rate effect is small because trade is a fairly small share of US GDP.
How monetary policy shifts aggregate demand. If the central bank increases the money supply:
- The money-supply line shifts right, so the interest rate falls.
- Lower interest rates encourage investment, home-building and other spending.
- Aggregate demand shifts right, raising output and prices in the short run.
A cut in the money supply does the opposite.
Targeting the interest rate. The US Federal Reserve sets a target for the federal funds rate, reviewed about every six weeks, and buys or sells bonds to hit it. Mankiw's reasons for targeting a rate rather than the money supply include two: the money supply is hard to measure precisely, and money demand shifts around. The two descriptions are equivalent: cutting the interest-rate target is expanding the money supply.
Worked example
Trace a cut in the central bank's interest-rate target from 4% to 3%:
- To push the rate down, the central bank buys bonds, adding to the money supply.
- The interest rate falls to 3%: money supply and demand balance at a lower rate.
- Borrowing is cheaper, so firms invest more and families buy more homes: investment rises.
- Aggregate demand shifts right: in the short run, output and the price level rise.
- In the long run, output returns to its natural rate and only prices are higher (monetary neutrality).
Text description
The theory of liquidity preference. Money demand slopes down: the higher the interest rate, the less money people want to hold. The money supply is a vertical line set by the central bank. When the central bank increases the money supply (from Supply 1 to Supply 2), the interest rate that balances the market falls (here from 5 to 3), which encourages investment and shifts aggregate demand to the right.
Common mistake
Thinking the central bank sets interest rates by decree. It sets a target and then changes the money supply (through open-market operations) until the market rate reaches it.
Key terms
- theory of liquidity preference
- Keynes's theory that the interest rate adjusts to balance the supply of and demand for money
- money demand
- how much wealth people want to hold as money; it falls as the interest rate rises
- monetary policy
- the central bank's setting of the money supply or interest rates
- federal funds rate
- the interest rate at which US banks lend to one another overnight; the Fed's target
Practise the key terms
Tap a card to turn it over. 4 cards.
| Front | Back |
|---|---|
| theory of liquidity preference | Keynes's theory that the interest rate adjusts to balance the supply of and demand for money |
| money demand | how much wealth people want to hold as money; it falls as the interest rate rises |
| monetary policy | the central bank's setting of the money supply or interest rates |
| federal funds rate | the interest rate at which US banks lend to one another overnight; the Fed's target |
Practice
Sort it
Which group does this belong to?
The central bank buys government bonds
The money supply rises and interest rates fallShow answer
Shifts aggregate demand right. The money supply rises and interest rates fall
The central bank raises its interest-rate target
Dearer borrowing cuts spendingShow answer
Shifts aggregate demand left. Dearer borrowing cuts spending
The central bank sells government bonds
The money supply falls and interest rates riseShow answer
Shifts aggregate demand left. The money supply falls and interest rates rise
The central bank cuts its interest-rate target
Cheaper borrowing raises spendingShow answer
Shifts aggregate demand right. Cheaper borrowing raises spending
Quick quiz
Tap an answer to check it.
In Mankiw's account, which of the three effects behind the aggregate-demand curve matters most for the US?
- Money is a small part of household wealth
- Trade is a fairly small share of US GDP
Show answer
The interest-rate effect. Higher prices raise money demand and interest rates, cutting investment.
Why does the money-supply line not slope?
- Money demand slopes down
Show answer
The central bank fixes the money supply; it doesn't depend on the interest rate. The supply of money is a policy choice.
What are Mankiw's reasons for the Fed targeting an interest rate rather than the money supply?
- It does; targeting the rate is a choice
Show answer
The money supply is hard to measure precisely, and money demand shifts around. Hitting a rate target still works through the money supply.
In short
- Liquidity preference: the interest rate balances money supply (fixed by the central bank) and money demand.
- A higher price level raises money demand and interest rates, cutting investment: the main reason aggregate demand slopes down.
- More money means lower interest rates and higher aggregate demand.
- Central banks target an interest rate, which is the same thing as steering the money supply.
Mastery check
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Check yourself
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What is the opportunity cost of holding money?
Show answer
The interest given up by not holding interest-bearing assets.
The central bank increases the money supply. What happens to the interest rate and aggregate demand in the short run?
Show answer
The interest rate falls and aggregate demand shifts right.
How often does the FOMC review its federal funds rate target, according to Mankiw?
Show answer
About every six weeks.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 21.
- On this site: Banks and the money supply and Fiscal policy and the multiplier.
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