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What Is the Connection Between Monetary Policy and Aggregate Demand?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 19 September 2014
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The relationship between monetary policy and aggregate demand is the way in which monetary policy is used as a means for influencing the level of aggregate demand in the economy. Aggregate demand simply refers to the calculation of the total level of demand in the economy. Where the level of demand and, consequently, consumption is exceedingly high it may create an unwanted macroeconomic trend like inflation. Monetary policies may be applied toward the reversal of the high demand, which is the cause of the unwanted high rate of inflation in the economy.

Usually, a central bank in a country serves as the main source of monetary policies, which are further channeled through other banks and financial institutions in the economy. The central bank keeps a close eye on the activities in the market. Whenever it notices that the aggregate demand is outstripping the rate of supply and leading to results like inflation, it will intervene to reverse the trend. In this case, the link between monetary policy and aggregate demand is the fact that the central bank will introduce policies meant to reduce the rate of demand for services and goods in the economy.

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One of the ways in which the central bank achieves this aim is by increasing the interest rates. The connection between monetary policy and aggregate demand is the fact that an increase in interest rates usually leads to a decrease in the level of aggregate demand, all being equal. When the central bank sets the rate for the interests, it will transmit this through the other banks, which will further transfer the interest rates to consumers; thereby, hopefully achieving the aim of the central bank.

An increase in the interest rates will affect the rate of consumption, because the banks will increase the rate of interest they charge for items like loans and credit. They will also tighten up their requirements for the qualifications for such items. When consumers no longer have easy access to money and other finances for the purchase of their products, the level of aggregate demand will drop, showing the connection between monetary policy and aggregate demand. This can also be done by reducing the circulation of liquid cash in the economy, creating the illusion of scarcity and the desire to conserve money by spending less. As a result, this will further reduce the rate of aggregate demand in the economy by the consumers.

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