Fluctuations in Aggregate Demand

The model with a money market, like the earlier models which ignored the money market, presents unemployment and inflation problems occurring alternately as aggregate demand fluctuates about full-employment output.

Economists often classify the disturbances which lead to fluctuations in aggregate demand as real or monetary, depending on whether they involve shifts in the expenditure functions or shifts in money supply and demand

The real disturbances, which are reflected as shifts in the IS curve.  include shifts in the investment expenditure function, shifts in the consumption expenditure function, changes in government purchases, and changes in consumption expenditures induced by changes in the tax function and transfer payments. When real disturbances produce declines in aggregate demand, money market effects dampen their impacts on output and employment, as compared with the case where money is absent.

In the model used in this chapter, once and for all money supply increases, occurring at full employment, provoke proportionate changes in prices and leave the equilibrium values for the market rate of interest, the real rate of interest, and real money balances unchanged.

Dynamic money supply increases, where the monetary authority raises the rate at which it is increasing the money supply from period to period, increase the equilibrium value for the market rate of interest when invoked at full employment, since they raise the equilibrium rate of inflation and the expected rate of inflation. Also, assuming that interest is not paid on money or that interest yields on money are inflexible relative to yields on other assets, the dynamic money supply increases reduce equilibrium real money balances. This means that they provoke more than proportionate increases in prices, comparing points in time before and after they occur.