How Do Fiscal and Monetary Policies Affect Aggregate Demand?

Aggregate demand (AD) is a macroeconomic concept representing the total demand for goods and services in an economy. This value is often used as a measure of economic well-being or growth. Both fiscal policy and monetary policy can impact aggregate demand because they can influence the factors used to calculate it: consumer spending on goods and services, investment spending on business capital goods, government spending on public goods and services, exports and imports.

Fiscal policy affects aggregate demand through changes in government spending and taxation. Those factors influence employment and household income, which then impact consumer spending and investment.

Monetary policy impacts the money supply in an economy, which influences interest rates and the inflation rate. It also impacts business expansion, net exports, employment, the cost of debt and the relative cost of consumption versus saving—all of which directly or indirectly impact aggregate demand.

In order to understand how monetary and policy affect aggregate demand, it's important to know how AD is calculated, which is with the same formula for measuring an economy's gross domestic product (GDP):

$\begin{aligned} &AD = C + I + G + (X - M)\\ &\textbf{where:}\\ &C=\text{Consumer spending on goods and services}\\ &I = \text{Investment spending on business capital goods}\\ &G = \text{Government spending on public goods and services}\\ &X = \text{Exports}\\ &M = \text{Imports}\\ \end{aligned}$​AD=C+I+G+(X−M)where:C=Consumer spending on goods and servicesI=Investment spending on business capital goodsG=Government spending on public goods and servicesX=ExportsM=Imports​

Fiscal policy determines government spending and tax rates. Expansionary fiscal policy, usually enacted in response to recessions or employment shocks, increases government spending in areas such as infrastructure, education and unemployment benefits.

According to Keynesian economics, these programs can prevent a negative shift in aggregate demand by stabilizing employment among government employees and people involved with stimulated industries. The theory is that extended unemployment benefits help to stabilize the consumption and investment of individuals who become unemployed during a recession.

Similarly, the theory says that contractionary fiscal policy can be used to reduce government spending and sovereign debt or to correct out-of-control growth fueled by rapid inflation and asset bubbles.

In relation to the formula for aggregate demand, fiscal policy directly influences the government expenditure element and indirectly impacts the consumption and investment elements.

Monetary policy is enacted by central banks by manipulating the money supply in an economy. The money supply influences interest rates and inflation, both of which are major determinants of employment, cost of debt and consumption levels.

Expansionary monetary policy involves a central bank either buying Treasury notes, decreasing interest rates on loans to banks, or reducing the reserve requirement. All of these actions increase the money supply and lead to lower interest rates.

This creates incentives for banks to loan and businesses to borrow. Debt-funded business expansion can positively affect consumer spending and investment through employment, thereby increasing aggregate demand.

Expansionary monetary policy also typically makes consumption more attractive relative to savings. Exporters benefit from inflation as their products become relatively cheaper for consumers in other economies.

Contractionary monetary policy is enacted to halt exceptionally high inflation rates or normalize the effects of expansionary policy. Tightening the money supply discourages business expansion and consumer spending and negatively impacts exporters, which can reduce aggregate demand.