Question

What should the Fed do if it wants to stabilize aggregate demand? What should Congress and the President do to stabilize aggregate demand?

Answer 1

If people become pessimistic about the future, they will spend less, causing the aggregate demand curve to shift to the left. If the Fed wants to stabilize aggregate demand, it should increase the money supply. As supply of money exceeds the demand then as per law of demand price or interest rates will fall. With the fall in interest rate the borrowing will become cheaper for both household and business organisations. This will result in stimulating residential and business investment. If the aggregate demand shifts to right and demand is exceesive then Fed should decrease the money supply as this will make tthe interest rates high and cost of borrowing will become expensive thus reducing Investment and price level. The Fed can also buy or sell bonds in open market to stabilize aggregate demand. If aggregate demand curve is shifted towards left it means spending is less. The Fed can buy treasury bonds through open market operations and this will inject money supply in the market thus boosting aggregate demand and Investments. The vice versa will hold true if Fed wants to decrease aggregate demand

The Congress can increase or decrese taxes or increase or decrese government spending to stabilize aggregate demand. Suppose the economy is overly heated and spending is too high, then in ordet to reduce money supply the Fed can raise taxes or reduce Government Spending. This will refuce the income of households and business organisations. As a result aggregate demand and Investments will fall. The vice versa can be done by government if it wants to boost Aggregate Demand.