AS and AD analysis, monetary and fiscal policy and supply-side Policies Flashcards
What is the theory of liquidity preference?
Uncertainty gives savers an incentive to hoard their savings in liquid assets, like money, rather than committing it to new capital projects. This is called liquidity preference which governs the price of financial securities and hence the rate of interest. If liquidity preference surged (due to pessimism in the economy) the pace of investment would decrease.
What is the crowding out effect?
occurs if government increases spending, thereby increasing money demand and interest rates. Now borrowing for households and firms becomes more costly, thus private investment decreases.
What should the government do if it wants to stabilize aggregate demand?
AD will shift to the left thereby lowering national income. Government can either boost expenditure or decrease taxes to encourage higher consumption and investment. If government does not step in, the central bank can lower the interest rate ( which should drive up borrowing and investment in new capital projects. Low interest rates also serve as an incentive to consume more thereby raising national income again.
Explain how each of the following developments would effect the supply of money, the demand for money and the interest rate:
a. The central bank’s bond traders buy bonds in open market operations.
c. The central bank reduces banks´ reserve requirements.
d. Households decide to hold more money to use for holiday shopping.
e. A wave of optimism boosts business investment and expands aggregate demand.
a) Money supply increases, interest rate falls, money demand decreases.
c) See a; as reserve requirements are loosened, money supply increases.
d) Money demand increases, interest rate rises.
e) Money demand increases as prices are pushed upwards, interest rate increases.
Suppose government spending increases, would the effect on aggregate demand be larger if the central bank took no action in response, or if the central bank were committed to maintaining a fixed interest rate?
An increase in G leads to higher interest rates. If the central bank would step in, interest rates would be lower (due to the increased money supply) and the expansionary effect would be even higher.
Explain why the AD curve slopes downwards, meaning that a decrease in the price level leads to an increase in quantity demanded.
i. The price level and consumption – the wealth effect: When prices fall, real money balances increase. Money becomes more valuable. A decrease in the price level makes consumers wealthier which encourages them to spend more.
ii. The price level and investment – the interest rate effect: When the price level falls, households decrease their money holdings. Thus, the supply of real money balances increases, which in turn pushes interest rates down and encourages firms to increase their investment spending.
iii. The price level and NEX – the exchange rate effect: returns on domestic interest bearing assets decrease. Thus, the supply of euros increases as investors sell euros for other currencies. The exchange rate of the euro depreciates relative to other currencies. Foreigners can buy more domestic goods as they receive more euros for each unit of their currency. NEX increases.
Explain the long-run AS curve.
In the long run, the AS curve is vertical, meaning that the long run output is solely determined by the supply of labour, capital, natural resources and the availability of technology.
Explain the positive relationship between the price level and output for the short-run AS curve.
The positive relationship between price and output is due to sticky wages or, sticky prices.
If the price level falls and nominal wages are constant, than real wages increase. Higher real wages mean the firm’s production cost have increased. As wages do not adjust quickly enough, a lower price level makes employment less profitable, so firms reduce the quantity of goods and services they supply.
Explain what Keynes meant by animal spirits.
Keynes argued that AD fluctuates because of irrational waves of pessimism and optimism. He used the term animal spirits for these irrational changes in attitude.
Explain how an increase in the money supply effects AD.
If M increases than interest rate falls which boosts borrowing and investment. Lower interest rates are an incentive for increased consumption.
Explain the arguments against an active stabilization policy.
Many economists argue that in particular in the short run the economy should be left to deal with fluctuations on its own. They argue that policies are uncertain both in terms of magnitude and in terms of timing. Rather than fine-
tuning the economy, automatic stabilizers can be used to balance negative shocks.
What are automatic stabilizers?
- Progressive taxation (for boom phases)
* Unemployment reliefs (for recession and depression).
Name and explain two market-oriented supply-side policies.
- Tax reform and welfare policy
- Flexible labour markets
- Reducing government spending
- Privatization and deregulation.
Name and explain two interventionist supply-side policies.
- Infrastructure investments
- Investment in education and training
- Research and development
- Regional and industrial policies.
