Money Supply & Aggregate Demand - Professor Ryan (2023)

Introduction

Professor Ryan explains how changes in the money supply affect Aggregate Demand.

Video

All, right? So before we look to see how the feds use of monetary policy will affect the aggregate market and deal with recessionary gaps and inflationary gaps, I first want to zoom in on one part of that process and I want to help you understand how the money supply effects.

Aggregate, demand, okay, all right.

So we already learned that changes in the money supply.

So we're gonna go over here to the money market and we're gonna say in the money market.

Okay, we have the interest rate is the price of money.

And then we have the quantity of money.

We know that we have money demand.

And we know that the money supply curve is a vertical line at least in the United States.

It is because it is directly controlled by well, mostly directly controlled by the Federal Reserve.

Okay.

Now what can happen here is I'm gonna I'm gonna actually give you two graphs, we're, gonna do two of them we're gonna do one for increasing the money supply and one for decreasing the money supply.

So we'll do another graph down here.

We got money.

Demand.

We have vertical a money supply curve.

Okay.

So up here, we're gonna see what happens when the money supply increases.

Okay, what happens to aggregate demand? So over there I'm actually going to put a a more aggregate market graph.

And so here we'll have real GDP on the horizontal.

And then we will have a price level on the vertical, right and I'm, not going to draw a short-run aggregate, supply curve or a long-run aggregate.

Supply curve, I'm, just gonna write draw an aggregate demand curve because that's all we care about in this particular segment of the lesson okay and then down here, I'm gonna draw exactly the same thing.

Aggregate, demand, real GDP and price level.

Okay, all right.

So over here, when the money supply increases when the money supply, increase is that's, a rightward shift of the money supply curve in the money market.

Okay.

And so this is money supply Prime.

And you can see here that wear it.

Now intersects with money.

Demand.

We have a lower interest rate.

So we have AI R, Prime, that's, a decrease in the interest rate.

Okay.

Now, the question is, well, what's gonna happen to other things when the interest rate decreases, well, we know that the first thing that happened was we had a decrease in the money supply.

And then that led to a excuse me, uh, that's, an increase in the money supply.

Sorry about that.

We had an increase in the money supply, which led to a decrease in interest rates.

Now what I want you to do is I want you to think back to unit two.

And one of the lessons that we did in Unit two was we talked about what would happen to consumption, which is spending by households and investment, which is spending by businesses.

We said what would happen if there was a change in interest rates that a change in interest rates would affect consumption.

And it would also affect investment, see households and businesses when interest rates are lower.

This is just a refresher that when when it costs less money to borrow money, we will borrow more when interest rates are lower I'm more interested in buying that car that I've been thinking about buying because I'm gonna pay less interest on it.

And so when interest rates are lower that leads to an increase in consumer spending.

It also leads to an increase in investment, see businesses.

They are also looking at interest rates.

And when interest rates go down they're thinking to themselves.

Man, we had this project that was not a good project.

It wasn't going to make us very much profit because interest rates were too high.

But now that interest rates are lower.

We can launch that program and make a lot of profit.

So a decrease in interest rates results in an increase in in consumption, an increase in investment, both of those are the lard probably the we understand the largest components of total expenditure.

So an increase in investment and an increase in consumption will lead to an increase in total expenditure in the economy.

And we know that an increase in total expenditure is associated with an increase in aggregate, demand in the economy.

And so when the money supply increases what we're also going to see over here in the aggregate market is an increase in aggregate demand.

So the aggregate demand curve ad prime is going to shift to the right when the money supply increases.

Now, what will that ultimately result in? Well? We know that when aggregate demand increases we have an increase in real GDP and by oaken's law, that's also going to result in a decrease in the unemployment rate.

Okay? So here's.

What I'm saying is that the Fed knows that if they increase the money supply, there should be a chain reaction of events that ultimately results in an increase in real GDP in the economy and a decrease in unemployment.

So when there's an unemployment problem in the economy, the Fed knows that they have monetary policy tools that they can use to affect the unemployment rate.

Now that doesn't mean that they should affect the unemployment rate.

It just means that they know they have to meet up and talk about whether they should be doing something about the unemployment rate if it is too high.

Okay, all right.

So that is an increase in the money supply.

Now, let's talk about a decrease in the money supply.

When the money supply decreases.

Okay, let's go to our our money market graph over here, that's going to be a leftward shift of the money supply curve.

Now, this is our starting interest rate.

This is our equilibrium interest rate at that level, a leftward shift of the money supply curve would then put it over here.

And now we're going to have MS money supply Prime.

And you can see here that this is the new intersection of money supply and money demand and that that is higher.

Now RI prime interest rate prime.

We have an increase in the interest rates.

And so the far first link up here is that a decrease in the money supply will result in a in an increase in interest rates.

Well, that means it's gonna cost more money to borrow money from the bank.

So consumers and businesses, don't want to borrow money, it's it's more expensive to borrow money.

So they're gonna spend less so consumption will go down and investment will go down.

And when these two very large components of total expenditure decrease when both of them decrease, that means that total expenditure itself will decrease and a decrease in total expenditure in the economy is associated with a decrease in aggregate.

Demand, okay.

And so a decrease in aggregate, demand means a leftward shift of the aggregate demand curve shift over to the left.

And we now have aggregate demand prime.

Okay.

And let me remind you that we know that when aggregate demand decreases that that results in a decrease in real GDP and by oaken's law, an increase in the unemployment rate, meaning, there will be more unemployment.

We will produce less stuff and more people will be out of work.

If the fed decreases the money supply, okay, and they know that this can happen.

We have seen this.

You know, we've been through this.

We have so much experience in the economy.

We've seen this happen many times.

Ok.

So this is how the money supply at demand.

And now we can take you to the final after in our macroeconomics journey, which is how monetary policy is used by the Fed to close recessionary gaps and close inflationary gaps.