ECON Ch 21

Money demand (piece of theory of liquidity preference)

The liquidity of money explains the demand for it: People choose to hold money instead of other assets that offer higher rates of return so they can use the money to buy goods and services. - Although many factors determine the quantity of money demanded, the theory of liquidity preference emphasizes the interest rate because it is the opportunity cost of holding money - An increase in the interest rate raises the cost of holding money and, as a result, reduces the quantity of money demanded. A decrease in the interest rate reduces the cost of holding money and raises the quantity demanded.

Changes in taxes

The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier and crowding-out effects -

How multiplier effect impacts AD

An increase in government purchases of billion can shift the aggregate-demand curve to the right by more than billion. This multiplier effect arises because increases in aggregate income stimulate additional spending by consumers.

Marginal Propensity to Consume (MPC)

The fraction of any change in disposable income spent for consumer goods; equal to the change in consumption divided by the change in disposable income

Marginal Propensity to Save (MPS)

The fraction of any change in disposable income that households save; equal to the change in saving divided by the change in disposable income.

Multiplier effect

the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending

Whenever the quantity of goods & services demanded changes for any given price level,

the aggregate-demand curve shifts

Expansionary open-market operations using larger variety of financial instruments (solution to liquidity traps)

- in addition to buying short-term gov't bonds, Fed could also buy mortgage-backed securities & longer-term gov't bonds to lower interest rates - sometimes called quantitative easing

How fiscal policy affects AD

- multiplier effect - crowding out effect

Formula for Spending Multiplier

1/(1-MPC) or 1/MPS

liquidity trap

A situation in a severe recession in which the Fed's injection of additional reserves into the banking system has little or no additional positive impact on lending, borrowing, investment, or aggregate demand.

Equilibrium in Money Market (piece of theory of liquidity preference)

According to the theory of liquidity preference, the interest rate adjusts to balance the supply and demand for money. There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded exactly balances the quantity of money supplied. If the interest rate is at any other level, people will try to adjust their portfolios of money and nonmonetary assets and, as a result, drive the interest rate toward the equilibrium.

Money Supply (piece of theory of liquidity of preference)

According to the theory of liquidity preference, the interest rate adjusts to bring the quantity of money supplied and the quantity of money demanded into balance. If the interest rate is above the equilibrium level, the quantity of money people want to hold is less than the quantity the Fed has created, and this surplus of money puts downward pressure on the interest rate. Conversely, if the interest rate is below the equilibrium level, the quantity of money people want to hold exceeds the quantity the Fed has created, and this shortage of money puts upward pressure on the interest rate.

theory of liquidity preference

Keynes's theory that the interest rate adjusts to bring money supply and money demand into balance

theory of liquidity preference illustrates an important principle:

Monetary policy can be described either in terms of the money supply or in terms of the interest rate - changes in monetary policy aimed at contracting AD can be described as either decreasing the money supply or raising the interest rate

One variable that shifts the AD: monetary policy

When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the right. Conversely, when the Fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the left.

Multiplier on changes in taxes

When the government cuts taxes and stimulates consumer spending, earnings and profits rise, further stimulating consumer spending.

Crowding-out impact on AD

When the government increases its purchases by billion, the aggregate demand for goods and services could rise by more or less than billion depending on the sizes of the multiplier and crowding-out effects.

forward guidance (solution to liquidity traps)

a central bank commitment to a future path of the policy interest rate - central bank commit itself to keeping interest rates low for an extended period of time

Automatic stabilizers

changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action - ex: tax system, gov't spending

there is another important determinant of the size of the shift in aggregate demand that results from a tax change:

households' perceptions about whether the tax change is permanent or temporary - If they expect the tax cut to be permanent, they will view it as adding substantially to their financial resources and, therefore, increase their spending by a large amount. - if households expect the tax change to be temporary, they will view it as adding only slightly to their financial resources and, therefore, increase their spending by only a small amount. In this case, the tax cut will have a small impact on aggregate demand.

The most important reason for the downward slope of the aggregate-demand curve is the

interest-rate effect

Crowding-out on changes in taxes

the increase in income raises money demand, increasing interest rates. Higher interest rates mean a higher cost of borrowing, which reduces investment spending.

Crowding-out effect

the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending

Fiscal policy

the setting of the level of gov't spending & taxation by government policymakers