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15 Cards in this Set
- Front
- Back
AD curve slopes downward for three reasons:
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- The wealth effect
- The interest-rate effect (most important for US economy) - The exchange-rate effect |
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The Theory of Liquidity Preference (Basics)
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Keynes' theory that the interest rate (r) adjusts to bring money supply and money demand into balance.
- money supply: assume fixed by the central bank, does not depend on interest rate - money demand reflects how much wealth people want to hold in liquid form - suppose household wealth includes only two assets: --Money: liquid, but no interest --Bonds: interest, but not as liquid -A household's 'money demand' reflects its preference for liquidity -The variables that influence money demand: Y, r, and p |
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Money Demand
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An increase in Y causes an increase in money demand, other things equal
(If Y rises: households want more g&s, so they need more money / to get money, they attempt to sell some of their bonds) |
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How r is determined
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MS curve is vertical: changes in r do not affect MS, which is fixed by central bank.
MD curve is downward sloping: a fall in r increases money demand |
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How interest-rate effect works
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1. A higher price level (P) raises money demand (MD)
2. Higher MD leads to a higher interest rate (r) 3. A higher r reduces the quantity of goods and services (Y) demanded |
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The effects of reducing the money supply
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- The Fed can raise r by reducing the money supply.
- An increase in r reduces the quantity of g&s demanded. |
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Liquidity traps
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Monetary policy stimulates aggregate demand by reducing the interest rate. Liquidity trap occurs when interest rate is zero.
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Fiscal Policy and Aggregate Demand
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Fiscal Policy: the setting of the level of gov't spending and taxation by gov't policymakers
-Expansionary fiscal policy: an increase in G and/or decrease in T (shifts AD right) -Contractionary fiscal policy: a decrease in G and/or increase in T (shifts AD left) |
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Fiscal policy has two effects on AD
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1. The Multiplier Effect: The shift in AD that results when fiscal policy increases income and thereby increases consumer spending
2. The Crowding-Out Effect: A fiscal expansion raises r, which reduces investment, which reduces the net increase in AD. The size of the AD shift may be smaller than the initial fiscal expansion. |
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Marginal propensity to consumer (MPC)
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The fraction of extra income that households consume rather than save (bigger MPC means bigger change in Y)
Change Y = [1/(1-MPC)] x Change in G |
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How crowding-out effect works
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- An increase in G initially shifts AD right
- But higher Y increases MD and r, which reduces AD |
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Fiscal Policy and Aggregate Supply
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Fiscal policy might also affect agg supply: a cut in the tax rate gives workers incentive to work more, so it might increase the quantity of g&s supplied and shift AS to the right. However, this effect is probably more relevant in the long run.
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The case FOR active stabilization policy
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-Keynes: 'animal spirits' cause waves of pessimism and optimism among households and firms, leading to shifts in aggregate demand and fluctuations in output and employment.
-Other factors cause fluctuations (booms/recessions abroad, stock market, etc.)...if policymakers do nothing, these fluctuations are destabilizing. |
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The case AGAINST active stabilization policy
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-Monetary policy affects economy with a long lag (I takes time to respond to r, most economist believe it takes at least 6 months to affect output and employment)
-Fiscal policy also works with a long lag (changes in G and T require long process of legislation) -By the time the policies affect agg demand, the economy's condition may have changed -Theses critics contend that policy makers should focus on long-run, like economic growth and low inflation |
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Automatic stabilizers
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Changes in fiscal policy that stimulate agg demand when economy goes into recession, without policymakers having to take any deliberate action (tax system, gov't spending)
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