- A tax cut or an increase in transfer payments such as unemployment benefits or welfare payments lead to increases aggregate demand. Both of these influences operate by increasing households’ disposable income.the greater the disposable income, the greater is the quantity of consumption goods and services that households plan to buy and the greater is aggregate demand.
- Government expenditure on goods and services is one component of aggregate demand. So if the government spends more on satellites, schools, and highways, aggregate demand increases.
Changes in Aggregate Demand
- The curve shift to the right from AD0 to AD1 when expected future income, inflation, or profit increases; government expenditure on goods and services increases; taxes are cut; transfer payments increase; the quantity of money increases and the interest rate falls; the exchange rate falls; or foreign income increases.
- The curve shift to the left from AD0 to AD2 when expected future income, inflation, or profit decreases; government expenditure on goods and services decreases; taxes increase; transfer payments decrease; the quantity of money decreases and the interest rate rises; the exchange rate rises; or foreign income decreases.
- Open market operations
- The discount rate
- Reserve requirements.
The Discount Rate
The discount rate is the interest rate that the Federal reserve charges financial institutions for short-term loans.
- By raising or lowering the discount rate, the Federal reserve can influence the activities of banks. Increasing the discount rate makes it more expensive for banks to borrow from the Fed. As with the cost of a higher federal funds rate, the cost of a higher discount rate is passed on to individuals and fi rms through higher interest rates. The result is fewer loans for business expansions and other investments to borrowers, and the economy slows down,however the effect of lowering the discount rate would be reversed and the economy would run faster.
The reserve requirements is specify the percentage of demand deposits that banks must keep on hand.
- Fed uses the reserve requirement more to ensure stability in the banking system than as a tool of monetary policy.
- Raise or lower reserve requirements, the change affects the availability of loans and the money supply.
- If the reserve requirement is lowered, banks hold less money in reserves and can lend more. This adds
to the money supply and the economy begins to expand,however the effect of raising the reserve requirement would be reversed and the economy would contract.