Ch 30

What is the theory of liquidity preference? How does it help explain the downward slope of the aggregate demand curve?

As real interest rates increase, demand for cash decreases. When interest rates increase, fewer people will start to invest and real GDP will decrease. This shows the inversely proportional relationship between output and price level in terms of investment, illustrated in the interest rate effect.

Use the theory of liquidity preference to explain how a decrease in money supply affects the aggregate demand curve.

A decrease in money supply will cause aggregate demand to shift to the left because investment will decrease.

The government spends $3 billion to buy police cars. Explain why aggregate demand might increase by more or less than $3 billion.

Aggregate demand will increase exactly by $3 billion because government spending and aggregate demand have a directly proportional relationship.

Suppose that a survey measures of consumer confidence indicate a wave of pessimism is sweeping the country. If policymakers do nothing, what will happen to aggregate demand? What should the Fed do if it wants to stabilize aggregate demand? If the Fed does nothing, what might Congress do to stabilize aggregate demand?

If policymakers do nothing, consumption and investment will decrease which will shift aggregate demand to the left. If the Fed wants to stabilize aggregate demand, it will increase the money supply. If the Fed does nothing, Congress might raise taxes or increase government spending.

Give an example of a government policy that acts as an automatic stabilizer. Explain why the policy has this effect.

Unemployment insurance is an automatic stabilizer because it mitigates the economy's sensitivity to shocks because it protects those who lose their jobs during a recession.