Chapter 34 - The Influence of Monetary and Fiscal Policy on Aggregate Demand

With a multiplier of 4, $20 billion of government spending generates $____ of demand for goods and services

$80 billion

The three steps to the interest-rate effect:

1. Higher price level raises money demanded 2. Higher money demand leads to higher interest rate 3. Higher interest rate reduces the quantity of goods and services demanded

Formula for multiplier:

1/(1- MPC)

Why does an increase increase in the price level shift the money demand curve to the right?

A higher price level increases the quantity of money demanded for any given interest rate

How does an increase in government purchases affect aggregate-demand?

AD shifts to the right because there is an increase in the total quantity of goods and services demanded

If the interest rate is ... (above/below) the equilibrium level, the quantity of money people want to hold is less than the quantity the Fed has created; surplus of money puts downward pressure on interest rate

Above

Changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action

Automatic stabilizers

If the interest rate is ... (above/below) the equilibrium level, the quantity of money people want to hold is greater than the quantity the Fed has created; shortage of money puts upward pressure on interest rate

Below

When the Fed ... (buys/sells) government bonds, the dollars it pays for the bonds are typically deposited in banks, and these dollars are added to bank reserves

Buys

When the government cuts spending, causing AD, production, and employment to fall in the short run, how can the Federal Reserve expand aggregate demand?

By increasing the money supply

What is the effect of a tax cut on consumer spending, AD, and production/employment?

Consumer spending increased, AD increased, economy's production and employment increased

When people are excessively optimistic (consumption and investment spending increased), how can the government adjust its monetary and fiscal policy?

Contract the money supply to raise interest rates and dampen aggregate demand

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

Crowding-out effect

When people are excessively pessimistic (consumption and investment spending reduced), how can the government adjust its monetary and fiscal policy?

Expand the money supply to lower interest rates and expand AD

Why is the exchange-rate effect not as significant as the interest-rate effect as the reason that AD slopes downward?

Exports and imports represent only a small fraction of U.S. GDP

The government's choices regarding the overall level of government purchases or taxes

Fiscal policy

How does government spending function as an automatic stabilizer?

In a recession, more people apply for public assistance (welfare, unemployment insurance) and government spending on these programs increases, stimulating AD

How does the tax system function as an automatic stabilizer?

In a recession, taxes fall automatically, which stimulates aggregate demand

Why does the multiplier effect occur?

Increase in aggregate income stimulate additional spending by consumers

When the Fed ... (inc/dec) the money supply, it lowers the interest rate and increases the quantity of goods and services demanded at any given price level, shifting AD to the right

Increases

Changes in monetary policy that aim to expand aggregate demand can be described either as . . . (money supply, interest rate)

Increasing the money supply or as lowering the interest rate

Monetary policy works by changing . . . , which influences investment spending

Interest rates

What is the effect of monetary expansion (inc. money supply) on interest rates, investment spending, and AD?

Interest rates reduced, investment spending increased, AD increase

Gives a tax break to firms that invest in new capital, causing higher investment and increasing AD

Investment tax credit

A ... (higher/lower) interest rate reduces the cost of borrowing and the return to saving

Lower

The fraction of extra income that a household consumes rather than saves

Marginal propensity to consumer (MPC)

Critics of active stabilization policy argue that by the time change in fiscal policy is passed and ready to implement, the condition of the economy . . .

May have changed

The crowding-out effect: when the government increases its purchases, the resulting increase in income causes . . . (money demand, equilibrium interest rate, investment goods)

Money demand increases, causing the equilibrium interest rate to rise. The increase in interest rate reduces the quantity of investment goods demanded

Why is the wealth effect the least important of the three effects?

Money holdings are a small part of household wealth

Why does the Federal Open Market Committee (FOMC) choose to set a target for the federal funds rate instead of the money supply?

Money supply is hard to measure with precision

Multiplier effect: a dollar of government purchases can generate . . .

More than a dollar of aggregate demand

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

Multiplier effect

What effect is demonstrated when the government cuts taxes and stimulates consumer spending, making earning and profits rise, stimulating further consumer spending

Multiplier effect

Multiplier effect: the government spends $20 billion. . . (national income, consumer spending)

National income (earnings and profits) rise by $20 billion and consumer spending increases by MPC x $20 billion

Why does the liquidity of money explain the demand for it?

People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services

If the interest rate is above the equilibrium level, how do people respond to bring the interest rate back to equilibrium?

People holding the surplus of money will get rid of it by buying interest-bearing bonds or depositing in banks. Bond issuers and banks respond to the surplus of money by lowering interest rates.

If the interest rate is below the equilibrium level, how do people respond to bring the interest rate back to equilibrium?

People try to increase their holding of money by reducing their holdings of interest-bearing bonds and assets. Bond issuers find that they must raise interest rates to attract buyers.

Why will a tax cut that is perceived to permanent have a great impact on aggregate demand?

People will be more likely to increase their spending by a large amount

What is the primary argument against monetary and fiscal policy?

Policies affect the economy with a long lag

What is the main argument proposed by economists that are against active stabilization policy?

Policies should focus on long-run goals (economic growth, low inflation) and should be left to deal with short-run fluctuations on its own

When the Fed ... (buys/sells) government bonds, the dollars it receives for the bonds are withdrawn from the banking system, and bank reserves fall

Sells

AD slopes downward: when a lower price level lowers the interest rate and investors move some of their funds overseas causing domestic currency to depreciate. Spending on net exports increases as goods are cheaper.

The exchange-rate effect

AD slopes downward: a lower price level lowers the interest rate as people try to lend out their excess money holdings, and the lower interest rate stimulates investment spending

The interest-rate effect

If the multiplier is 4 and there is a $10 billion fall in net exports, why does it mean there is a $40 billion contraction in aggregate demand?

The multiplier effect applies to any event that alters spending on any component of GDP

What is the lag in fiscal policy largely attributable to?

The political process; passing legislation is a lengthy process

What is the most important economic stabilizer?

The tax system

AD slopes downward: a lower price level raises the real value of households' money holdings, and higher real wealth stimulates consumer spending

The wealth effect

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

Theory of liquidity preference

If the interest rate is not at the equilibrium interest rate, how would people respond?

Trying to adjust their portfolios of assets to drive the interest rate toward the equilibrium

When does a tax cut have a great impact on aggregate demand?

When it is perceived to be permanent

Why is the interest rate the opportunity cost of holding money?

You lose the interest you could have earned as an interest-bearing bond when you hold wealth as cash in your wallet