Ch 21: The Influence of Monetary and Fiscal Policy on Aggregate Demand

Question 1

For the U.S. economy, the most important reason for the downward slope of the aggregate-demand curve is the

Answer 1

interest-rate effect

Question 2

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

Answer 2

Theory of liquidity preference

Question 3

What is the opportunity cost of holding money?

Answer 3

Interest Rate

Question 4

State how the theory of liquidity preference explains how the total quantity of goods and services demanded in the economy changes as the price level changes.

Answer 4

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

Question 5

To sum up: 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.

Answer 5

Cool

Question 6

the interest rate that banks charge one another for short-term loans.

Answer 6

Federal Funds Rate

Question 7

The 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.

Answer 7

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Question 8

The lessons from this analysis are simple: Changes in monetary policy aimed at expanding aggregate demand can be described either as increasing the money supply or as lowering the interest rate. Changes in monetary policy aimed at contracting aggregate demand can be described either as decreasing the money supply or as raising the interest rate.

Answer 8

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Question 9

a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment

Answer 9

Quantitative Easing

Question 10

Some economists have suggested that the possibility of hitting the zero lower bound for interest rates justifies setting the target rate of inflation well above zero. Under zero inflation, the real interest rate, like the nominal interest, can never fall below zero. But if the normal rate of inflation is, say, 4 percent, then the central bank can easily push the real interest rate to negative 4 percent by lowering the nominal interest rate toward zero. Thus, moderate inflation gives monetary policymakers more room to stimulate the economy when needed, reducing the risk of hitting the zero lower bound and having the economy fall into a liquidity trap.

Answer 10

Wow another advantage of inflation

Question 11

By how much does this $20 billion order from the government shift the aggregate-demand curve? At first, one might guess that the aggregate-demand curve shifts to the right by exactly $20 billion. It turns out, however, that this is not the case. There are two macroeconomic effects that cause the size of the shift in aggregate demand to differ from the change in government purchases.

Answer 11

1) The Multiplier Effect

2) The Crowding Effect

Question 12

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

Answer 12

multiplier effect

Question 13

This positive feedback from demand to investment is sometimes called

Answer 13

the investment accelerator.

Question 14

What is the money multiplier formula?

Answer 14

1/(1-MPC)

Question 15

Is money multiplier effect limited to government purchases?

Answer 15

No

Question 16

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

Answer 16

crowding-out effect

Question 17

To sum up: When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion depending on the sizes of the multiplier and crowding-out effects. The multiplier effect makes the shift in aggregate demand greater than $20 billion. The crowding-out effect pushes the aggregate-demand curve in the opposite direction and, if large enough, could result in an aggregate-demand shift of less than $20 billion.

Answer 17

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Question 18

The primary argument against active monetary and fiscal policy is that these policies affect the economy with a long lag. As we have seen, monetary policy works by changing interest rates, which in turn influence investment spending. But many firms make investment plans far in advance. Thus, most economists believe that it takes at least 6 months for changes in monetary policy to have much effect on output and employment. Moreover, once these effects occur, they can last for several years. Critics of stabilization policy argue that because of this lag, the Fed should not try to fine-tune the economy.

Answer 18

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Question 19

Fiscal policy also works with a lag, but unlike the lag in monetary policy, the lag in fiscal policy is largely attributable to the political process. In the United States, most changes in government spending and taxes must go through congressional committees in both the House and the Senate, be passed by both legislative bodies, and then be signed by the president. Completing this process can take months or, in some cases, years. By the time the change in fiscal policy is passed and ready to implement, the condition of the economy may have changed.

Answer 19

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Question 20

Some economists argue that the government should avoid active use of monetary and fiscal policy to try to stabilize the economy. They claim that these policy instruments should be set to achieve long-run goals, such as rapid economic growth and low inflation, and that the economy should be left to deal with short-run fluctuations on its own. These economists may admit that monetary and fiscal policy can stabilize the economy in theory, but they doubt whether it can do so in practice.

Answer 20

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Question 21

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

Answer 21

Automatic stabilizers

Question 22

The most important automatic stabilizer is the

Answer 22

tax system

Question 23

Some government spending also acts as an automatic stabilizer. In particular, when the economy goes into a recession and workers are laid off, more people apply for unemployment insurance benefits, welfare benefits, and other forms of income support. This automatic increase in government spending stimulates aggregate demand at exactly the time when aggregate demand is insufficient to maintain full employment. Indeed, when the unemployment insurance system was first enacted in the 1930s, economists who advocated this policy did so in part because of its power as an automatic stabilizer.

Answer 23

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