Principles of Economics Chapter 34

Explain the aftermath of the multiplier effect.

Consumer spending increases, so firms have to hire more workers to meet the new demand and will see higher profits. Higher earnings and profits stimulate consumer spending once again and so on. Thus... higher demand leads to higher income, which in turn leads to even higher demand.

multiplier effect

additional shifts in aggregate-demand that result when expansionary fiscal policy increases income and thereby increases consumer spending; each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar

federal funds rate

interest rate banks charge each other for loans; feds set their policy to meet the target for the federal funds rate

marginal propensity to consume (MPC)

the fraction of extra income that household consumers rather than saves Example: if MPC is 3/4, then for every dollar a household earns, the household spends $0.75(3/4) and saves $0.25.

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 levels of government spending and taxation by government policymakers

What is stabilization policy?

the use of government policy to reduce the severity of recessions and rein in excessively strong expansions

What are the two options does the central bank have in a liquidity trap?

1. Forward guidance. The central bank could promise to keep interest rates low for a certain amount of time, and this might encourage investment spending. 2. Quantitative easing. The central bank could purchase mortgage-backed securities or longer-term government bonds to lower interest rates. This will increase quantity of bank reserves.

What are the two specified reasons that the Fed wants to use the federal funds as its target?

1. Money supply is hard to measure with sufficient precision. 2. Money demand fluctuates over time.

What are the two implications of the Employment Act?

1. The gov. should avoid being a cause of economic fluctuations. They should be careful when wanting to implement big changes in monetary or fiscal policy. When large changes do have to occur, both policymakers should be aware of each other's actions. 2. The gov. should respond to changes in the private economy to stabilize aggregate demand.

Describe the negative relationship between the price level and quantity of goods and services demanded.

A lower price level reduces money demand, leading to a lower interest rate and a larger quantity of goods and services demanded.

Why would it be inefficient to set a strict balanced-budget for the government?

During a recession, the government would be forced to raise taxes or cut spending. There would be no room to let the economy recover on it own or implement policies (such as putting more money toward employment) to help. A strict balanced-budget would eliminate the automatic stabilizers (the tax system and government spending).

When policymakers change the money supply or level of taxes, do they shift the aggregate-demand curve directly or indirectly? What about when the government alters its own purchases?

Indirectly; alters the spending decisions made by the public Directly; alters their own spending decisions and the decisions of other firms or people involved

What happens 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, which shifts the aggregate-demand curve to the right.

theory of liquidity preference

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

Explain how changes in taxes can affect the aggregate-demand curve.

Lowering taxes increases consumer spending, so the curve shifts to the right. Changes in taxes also experience the multiplier effect and the crowding-out effect. When taxes decrease, it stimulates consumer spending, while earnings and profits rise (multiplier) and interest rates increase. These higher interest rates lead to less investment spending (crowding-out).

According to Keynes, how do pessimism and optimism affect the economy?

Pessimism causes a decrease in consumption and investment spending. The result is reduced aggregate demand, lower production, and higher unemployment. Optimism causes an increase in consumption and investment spending. The result is higher aggregate demand, higher production, and inflationary pressure.

What is the most important automatic stabilizer?

Tax system. When the economy goes into a recession, the taxes collected automatically fall due to the lower income being taxed.

What is the problem with the view that monetary and fiscal policy should be used to achieve long-term goals?

The economy is always changing, and the changes are unpredictable. The best policymakers can do is to respond to economic changes as they occur.

What is the main argument against fiscal and monetary policy to stabilize short-term economic fluctuations?

The policies affect the economy with a long lag. Most economists believe that it takes at least 6 months for monetary policy to affect output and employment in the economy, and in a short-term fluctuation, it might be too late. It would be best to use these policies for long-term goals. There is also a lag in fiscal policy, but this is mostly due to the slow process of political changes.

According to the theory of liquidity, what happens when interest rate is above equilibrium level?

The quantity of money that people want to hold is less than the quantity of money the Fed has supplied. The people who hold an excess of money will want to buy interest-bearing bonds or deposit it in interest-bearing accounts. To respond to the surplus of money, the bond issuers and banks will lower interest rates. If bonds are not being sold and interest-bearing accounts are not being invested in, bond issuers and banks will increase interest rates to attract consumers,

T or F: The theory of liquidity preference illustrates that monetary policy can be described either in terms of money supply or in terms of the interest rates.

True

What is a "liquidity trap?" How does this come about?

When interest rates reach close to zero, banks might find it more profitable to hold their money and not loan it out. There is hardly any profit to make when there is hardly any interest to accumulate on loans. In this case, aggregate demand, production, and employment may be "trapped" at low levels, hence the name.

Does the Federal Reserve watch the stock market? Why or why not?

Yes. The stock market is part of their indication as to how the economy is doing, but it is only a small part. Fluctuations of the stock market can give the Fed hints about upcoming recessions. It also helps evaluate aggregate demand. Reminder: participants in the stock market monitor the Fed to make plans for future investments.

Quick Quiz 9: Which of the following is an example of an automatic stabilizer? When the economy goes into a recession... a. more people become eligible for unemployment insurance benefits. b. stock prices decline, particularly for firms in cyclical industries. c. Congress begins hearings about a possible stimulus package. d. the Fed changes its target for the federal funds rate.

a. more people become eligible for unemployment insurance benefits.

Quick Quiz 3: The Fed's target for the federal funds rate... a. is an extra policy tool for the central bank, in addition to and independent of the money supply. b. commits the Fed to set a particular money supply so that it hits the announced target. c. is a goal that is rarely achieved because the Fed can determine only the money supply. d. matters to banks that borrow and lend federal funds but does not influence aggregate demand.

b. commits the Fed to set a particular money supply so that it hits the announced target.

Quick Quiz 4: If the government wants to expand aggregate demand, it can _______ government purchases or ________ taxes. a. increase; increase b. increase; decrease c. decrease; increase d. decrease; decrease

b. increase; decrease

Quick Quiz 1: According to the theory of liquidity preference, an economy's interest rate adjusts... a. to balance the supply and demand for loanable funds. b. to balance the supply and demand for money. c. one-for-one to changes in expected inflation. d. to equal the interest rates prevailing in world financial markets.

b. to balance supply and demand for money.

Quick Quiz 2: If the central bank wants to contract aggregate demand, it can _______ the money supply and thereby ________ the interest rate. a. increase; increase b. increase; decrease c. decrease; increase d. decrease; decrease

c. decrease; increase

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

When does the multiplier effect occur?

changes in government spending, consumption, investment, and net exports (any component of GDP)

Quick Quiz 5: With the economy in a recession due to inadequate aggregate demand, the government increases its purchases by $1,200. Suppose the central bank adjusts the money supply to hold the interest rate constant, investment spending remains unchanged, and the MPC is 2/3. How large is the increase in aggregate demand? a. $400 b. $800 c. $1,800 d. $3,600

d. $3,600

Quick Quiz 7: Suppose a wave of negative "animal spirits" overruns the economy, and people become pessimistic about the future. To stabilize aggregate demand, the Fed could _______ its target for the federal funds rate or Congress could ________ taxes. a. increase; increase b. increase; decrease c. decrease; increase d. decrease; decrease

d. decrease; decrease

Quick Quiz 8: Monetary policy affects the economy with a lag mainly because it takes a long time... a. for central banks to make policy changes. b. to change the money supply after a policy decision has been made. c. for a change in the money supply to affect interest rates. d. for a change in interest rates to affect investment spending.

d. for a change in interest rates to affect investment spending.

Quick Quiz 6: If the central bank in the preceding question had instead held the money supply constant and allowed the interest rate to adjust, the change in aggregate demand resulting from the increase in government purchases would have been... a. larger b. the same. c. smaller but still positive. d. negative.

d. smaller but positive

investment accelerator

higher government demand spurs higher demand for investment goods

What is the difference between nominal interest rate and real interest rate?

nominal interest rate - what interest rates are at real interest rate - the current interest rate adjusted for inflation