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Orange Brigade
Theory of Liquidity Preference- Keynes's Theory that Interest
rate adjusts to bring Money Supply and demand into Balance
1. Money Supply- Fixed by Central Bank, unresponsive to interest rate
2. Money Demand- recall components that affect AD curve
As real income rises, Households purchase more goods and services, so demand
for money increases.
Households sell bonds to increase money holdings
Increase in IR increases cost of holding money. Therefore, quantity of money
demanded decreases. Decreasing IR decreases cost of holding money, so
money demand increases
As a result, Money Demand curve slopes downwards
3. Equilibrium in Money Market- If interest rate isn’t at equilibrium, people will buy
or sell assets to drive market towards equilibrium.
Determination of IR
Interest
rate
MS
r1
MD1
M
Quantity fixed
by the Fed
Monetary Policy and Aggregate Demand
Fed uses monetary policy to shift the aggregate Demand
curve by altering the money supply.
Recall that the Fed adjusts the interest rate by changing the
Fed Funds Rate
Fed uses Open Market operations to change the interest
rate and to shift the AD curve
The Effects of Reducing the Money Supply
The Fed can raise r by reducing the money supply.
P
Interest
MS2 MS1
rate
r2
P1
r1
AD1
MD
M
AD2
Y2
Y1
Y
An increase in r reduces the quantity of g&s demanded.
THE INFLUENCE OF MONETARY AND FISCAL POLICY
5
Fiscal Policy- Setting of the level of government
spending and taxation
Expansionary policies shift AD rightwards
increase in government purchases or decrease in taxation
Contractionary policies shift AD leftwards
decrease in government purchases or increase in taxation
Multiplier effect- additional shifts in AD resulting when fiscal policy
increases income and thereby consumer spending.
Increase in real income increases consumer spending, `
shifting AD rightwards
Marginal Propensity to Consume- Fraction of extra income
households consume rather than save
Formula for the multiplier:
G is the change in G,
Y and C are the ultimate changes in Y and C
Y = C + I + G + NX
Y = C + G
identity
I and NX do not
change
Y = MPC Y + G
MPC Y 1
Y =
Y
1 – MPC
G
because C =
solved for
The Multiplier Effect
P
AD1
AD2
AD3
P1
Y1
Y
Crowding-Out Effect is also
affected by Fiscal Policy
Expansionary policy increases interest rate,
which reduces investment,
which reduces the net increase in aggregate demand.
So, the size of the AD shift may be smaller than the
initial fiscal expansion.
Changes in Taxes
Tax cuts increase take-home pay for households, increasing consumer
spending and shifting AD to the right.
If household perceives tax cut to be permanent, shift is larger.
Using policy to stabilize the economy
Booms, recessions, and crashes cause fluctuations in the market
Active stabilization- supporters of active stabilization believe it is the
government’s responsibility to regulate the economy.
Expansionary policy should be used during a recession,
contractionary policy should be used during periods of rapid
inflation
Against Active stabilization- critics of active stabilization claim that
monetary and fiscal policy affects economy with a long lag
Because firms create investment plans in advance,
investment takes time to respond to changes in IR
Because government purchases and taxes require
congressional approval, G and T require time
These lags can destabilize the economy
Automatic stabilizers- changes in fiscal policy that stimulate
AD when economy goes into recession, without
policymakers having to take any deliberate action
Include tax system and government spending