Ch. 34 Homework for Grooup C

CHAPTER 34 | INFLUENCES OF MONETARY AND FISCAL POLICY

1.        What is the theory of liquidity preference and how does it help explain the downward slope of the aggregate demand curve?

The theory of liquidity preference as proposed by John Maynard Keynes, the author of the book The General Theory of Employment, Interest, and Money. According to his theory, the interest rate adjusts to bring money supply and money demand into balance.  Note that the “interest rate” being discussed are both the nominal interest rate and the real interest rate because we are assuming that they will move together.

It helps explain the aggregate demand curve because an increase in the price level shifts the money-demanded curve to the right.  This increase in money demand causes the interest rate to rise.  Because the interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods and services demanded.  This negative relationship between the price level and quantity demanded is represented with a downward-sloping aggregate-demand curve.

2.       Use the liquidity preference theory to explain how decreases in the money supply affect the AD curve.

A decrease in the money supply, increases the equilibrium interest rate.  Because the interest rate is the cost of borrowing, the rise in the interest rate decreases the quantity of goods and services demanded at a given price.  Thus the aggregate-demand curve shifts to the left.

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

Tax system is the most important automatic stabilizer.  When the economy goes into a recession, the amount of taxes collected by the government falls automatically because almost all  taxes are closely tied to economic activity.  The personal income tax depends on households’ incomes, the payroll tax depends on workers’ earnings, and the corporate income tax depends on firms’ profits.  Because incomes, earnings, and profits all fall in a recession, the government’s tax revenue falls as well.  This automatic tax cut stimulates aggregate demand and, thereby, reduces the magnitude of economic fluctuations.