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The money supply in Muckland is $100 billion. Nominal GDP is $800 billion and real GDP is $200 billion. What
are the price level and velocity in Muckland?
The price level is 4 and velocity is 8.
The aggregate demand and aggregate supply graph has
the price level on the vertical axis. The price level can be measured by the GDP deflator.
By about 1973, U.S. policymakers had learned that
there is no trade-off between inflation and unemployment in the long run
In the late 1960s, economist Edmund Phelps published a paper that
argued that there was no long-run tradeoff between inflation and unemployment.
If there are floods or droughts or a decrease in the availability of raw materials
output falls in the short run
Which of the following can explain the upward slope of the short-run aggregate supply curve?
nominal wages are slow to adjust to changing economic conditions
According to liquidity preference theory, the opportunity cost of holding money is
the interest rate on bonds.
The idea that a decrease in the price level raises the real value of households’ money holdings, which increases
consumer spending and the quantity of goods and services demanded is known as
the wealth effect.
Which of the following shifts long-run aggregate supply right?
an increase in either technology or the human capital stock
Which of the following is not implied by the quantity equation?
With constant money supply and velocity, an increase in output creates a proportional increase in the
price level.
Suppose monetary neutrality holds and velocity is constant. A 4 percent increase in the money supply
increases the price level by 4 percent
If the graphs apply to an economy such as the U.S. economy, then the slope of the AD
curve is primarily attributable to the
interest-rate effect.
Other things the same, the aggregate quantity of output supplied will increase if the price level
is higher than expected so that firms believe the relative price of their output has increased.
When the government reduces taxes, which of the following decreases?
None of the above is correct
Which of the following is an example of an adverse supply shock?
a worldwide drough
Suppose that M is fixed. According to the quantity equation, which of the following would make the price level
higher?
Y falls or V rises
Suppose that the money supply increases. In the short run this decreases unemployment according to
both the short-run Phillips curve and the aggregate demand and aggregate supply model
Suppose there is a tax increase. To stabilize output, the Federal Reserve will
increase the money supply.
Which of the following would both shift aggregate demand right?
taxes decrease and government expenditures increase.
In the long run, which of the following depends primarily on the growth rate of the money supply?
the inflation rate but not the natural rate of unemployment
A movement to the right along a given short-run Phillips curve could be caused by
contractionary monetary policy, but not an increase in the natural rate of unemployment
Assume the MPC is 0.625. Assume there is a multiplier effect and that the total crowding-out effect is $12
billion. An increase in government purchases of $30 billion will shift aggregate demand to the
right by $68 billion
As aggregate demand shifts left along the short-run aggregate supply curve,
unemployment is higher and inflation is lower
If the economy unexpectedly went from inflation to deflation
creditors would gain at the expense of debtors
Which of the following is an example of an increase in government purchases?
The government builds new roads.
Higher inflation makes relative prices
more variable, making it less likely that resources will be allocated to their best use.
In the mid-1970s the price of oil rose dramatically. This
shifted aggregate supply left, the price level rose, and real GDP fell
If a central bank increases the money supply in response to an adverse supply shock, then which of the
following quantities moves closer to its pre-shock value as a result?
output but not the price level
Which of the following would cause prices and real GDP to rise in the short run?
an increase in the money supply
The long-run Phillips curve would shift to the left if
labor markets become more flexible but not if the money supply growth rate increased.
According to the Phillips curve, unemployment and inflation are negatively related in
the short run, but not in the long run.
actual inflation rate unemployment rate
5% 4%
4% 4.5%
3% 5%
2% 5.5%
These points are consistent with the theoretical short-run Phillips curve, but not with the long-run Phillips
curve.
When there is inflation, the number of dollars needed to buy a representative basket of goods
increases, and so the value of money falls.
In a certain economy, when income is $500, consumer spending is $375. The value of the multiplier for this
economy is 5. It follows that, when income is $510, consumer spending is
$383.
If M = 12,000, P = 3, and Y = 32,000, then velocity =
8. Velocity will rise if money changes hands more frequently
The idea of menu costs suggests that
firms alter prices more frequently as inflation increases.
Which of the following properly describes the interest-rate effect?
A lower price level leads to lower money demand; lower money demand leads to lower interest rates; a
lower interest rate increases the quantity of goods and services demanded.
Economic expansions in Europe and China would cause
the U.S. price level and real GDP to rise.
If real output in an economy is 1,000 goods per year, the money supply is $300, and each dollar is spent an
average of 4 times per year, then according to the quantity equation, the average price level is
1.20.
In which of the following cases would the quantity of money demanded be largest?
r = 0.03, P = 1.3
A decrease in expected inflation shifts
the short-run Phillips curve left
As the price level rises, the value of money
decreases, so people must hold more money to purchase goods and services.
The initial impact of the repeal of an investment tax credit is to shift
aggregate demand left.
In the 1970’s the Federal Reserve responded to an adverse supply shock. Its policy made
the recession that followed smaller, but in doing so produced a less favorable tradeoff between inflation
and unemployment.
The logic of the multiplier effect applies
to any change in spending on any component of GDP.
If the Federal Reserve decreases the rate at which it increases the money supply, then unemployment is higher
in
the short run but not the long run
The economy is in long-run equilibrium when Senator Soldout argues that the Fed should do more to fight
unemployment. He argues that if the Fed increased the money supply faster, more workers would find jobs. The
Senator’s argument
is true for the short run but not the long run.
Which of the following statements is correct for the long run?
Output is determined by the amount of capital, labor, and technology; the interest rate adjusts to balance
the supply and demand for loanable funds; the price level adjusts to balance the supply and demand for
money.
A central bank sets out to reduce unemployment by changing the money supply growth rate. The long-run
Phillips curve shows that in comparison to their original rates, this policy will eventually lead to
an increase in the inflation rate and no change in the unemployment rate
The “natural” rate of unemployment is the unemployment rate toward which the economy gravitates in the
long run, and the natural rate changes over time.
If a central bank reduced inflation by 4 percentage points and this made output fall by 5 percent for one year
and 3 percent for another year and the unemployment rate rise 2.5 percent above its natural rate for one year
and 1.5 percent above its natural rate for another year, the sacrifice ratio was
2.
The Fisher effect is crucial for understanding changes over time in
the nominal interest rate.
Other things the same, as the price level rises, the real value of money
falls and the exchange rate rises.
Banks advertise
the nominal interest rate, which is how fast the dollar value of savings grows.
“Monetary policy can be described either in terms of the money supply or in terms of the interest rate.” This
statement amounts to the assertion that
our analysis of monetary policy is not fundamentally altered if the Federal Reserve decides to target an
interest rate.
According to monetary neutrality and the Fisher effect, an increase in the money supply growth rate eventually
increases
inflation and nominal interest rates, but does not change real interest rates
As the price level decreases, the value of money
increases, so people must hold less money to purchase goods and services
An aide to a U.S. Congressman computes the effect on aggregate demand of a $20 billion tax cut. The actual
increase in aggregate demand is less than the aide expected. Which of the following errors in the aide’s
computation would be consistent with an overestimation of the impact on aggregate demand?
The aide thought the tax cut would be permanent, but the actual tax cut was temporary.
. In the short run, a decrease in the money supply causes interest rates to
increase, and aggregate demand to shift left.
The real interest rate is 4 percent and the nominal interest rate is 6 percent. Is there inflation or deflation? What
is the inflation or deflation rate?
inflation; 2 percent
Liquidity refers to
the ease with which an asset is converted into a medium of exchange
Monetary Policy in Mokania:
Mokania has had inflation of 15% for many years. Mokania establishes a new central bank, the Bank of
Mokania, with the hopes of reducing the inflation rate.

Refer to Monetary Policy in Mokania. The Bank of Mokania reduced inflation to its announced goal of 5%.
However its efforts made the unemployment rate rise by 10 percentage points for a year while output fell by 30
percent for a year. Which of the following is correct?

Initially people’s inflation expectations had been higher than 5%. The sacrifice ratio was 3
Which of the following is correct according to the long-run Phillips curve?
Monetary policy cannot change the natural rate of unemployment, but other government policies can.
The price level rises if either
money demand shifts leftward or money supply shifts rightward; this rise in the price level is associated
with a fall in the value of money.
As the price level rises
people will want to buy fewer bonds, so the interest rate rises.
If, at some interest rate, the quantity of money supplied is less than the quantity of money demanded, people will
desire to
sell interest-bearing assets, causing the interest rate to increase
In the long run, an increase in the stock of human capital
makes the price level fall, while increases in the money supply make prices rise.
Suppose that velocity rises while the money supply stays the same. It follows that
P x Y must rise.
In the long run a reduction in the money supply growth rate affects
the inflation rate but not the natural rate of unemployment.
Other things the same, as the price level falls,
a dollar buys more domestic goods.
Which of the following is correct?
Over the business cycle investment fluctuates more than consumption
The multiplier for changes in government spending is calculated as
1/(1 – MPC).
Which of the following shifts the short-run aggregate supply curve to the right?
a decrease in the expected price level
The consequences of the Volcker disinflation demonstrated that when Volcker announced his intention to
reduce inflation quickly, on average the public thought
inflation would fall but not by as much or as quickly as Volcker claimed.
With the value of money on the vertical axis, the money supply curve is
vertical because we assume the central bank controls the money supply.
If wages are sticky, then a greater than expected increase in the price level
reduces the real costs of production, so the aggregate quantity of goods and services rises
In the long run, an increase in the money supply growth rate
increases inflation and shifts the short-run Phillips curve right.
Monetary neutrality means that a change in the money supply
does not change real GDP. Most economists think this is a good description of the economy in the long
run but not the short run.
When the money market is drawn with the value of money on the vertical axis, if the Federal Reserve sells
bonds, then the money supply curve
shifts left, causing the price level to fall.
A shock increases the costs of production. Given the effects of this shock, if the central bank wants to return
the unemployment rate towards its previous level it would
increase the rate at which the money supply increases. However, this will make inflation higher than its
previous rate
The marginal propensity to consume (MPC) is defined as the fraction of
extra income that a household consumes rather than saves
If the MPC is 5/6 then the multiplier is
6, so a $200 increase in government spending increases aggregate demand by $1200
Federal Reserve (Fed):
the central bank of the United States.
central bank
An institution designed to oversee the banking system and regulate the quantity of money in the economy.
The Fed is run by a Board of Governors with 7 members who serve 14-year terms.
The Board of Governors has a chairman who is appointed for a four-year term.

The current chairman is Ben Bernanke.

The Federal Reserve System is made up of 12 regional Federal Reserve Banks located in
major cities around the country.
true
One job performed by the Fed is the regulation of banks to ensure the health of the nation’s
banking system.
a. The Fed monitors each bank’s financial condition and facilitates bank transactions by
clearing checks.

b. The Fed also makes loans to banks when they want (or need) to borrow.

The second job of the Fed is to control the quantity of money available in the economy.
true
money supply
the quantity of money available in the economy.
monetary policy
the setting of the money supply by policymakers
in the central bank.
If the Fed wants to increase the supply of money
it creates dollars and uses them to
purchase government bonds from the public through the nation’s bond markets.
If the Fed wants to lower the supply of money,
it sells government bonds from its
portfolio to the public. Money is then taken out of the hands of the public and the supply
of money falls.
reserves:
deposits that banks have received but have not loaned
out.
fractional-reserve banking:
a banking system in which banks hold only
a fraction of deposits as reserves.
reserve ratio:
the fraction of deposits that banks hold as reserves.
money multiplier
the amount of money the banking system generates
with each dollar of reserves.
money multiplier =
1/reserve ratio
bank capital:
the resources a bank’s owners have put into the
institution.
leverage
the use of borrowed money to supplement existing funds for
purposes of investment
leverage ratio:
the ratio of assets to bank capital.
The leverage ratio is $1,000/$50 = 20.
A leverage ratio of 20 means that, for every dollar of capital that has been contributed by
the owners, the bank has $20 of assets.
c. Because of leverage, a small change in assets can lead to a large change in owner’s
equity.
capital requirement
a government regulation specifying a minimum
amount of bank capital.
discount rate
the interest rate on the loans that the Fed makes to
banks.
A higher discount rate discourages banks from borrowing from the Fed and likely
encourages banks to hold onto larger amounts of reserves. This in turn lowers the
money supply.
true
reserve requirements:
regulations on the minimum amount of
reserves that banks must hold against deposits.
federal funds rate:
: the short-term interest rate that banks charge one
another for loans.
When the federal funds rate rises or falls
other interest rates often move in the same
direction.
The inflation rate is measured
as the percentage change in the Consumer Price Index, the GDP
deflator, or some other index of the overall price level.
When the price level rises,
people have to pay more for the goods and services that they
purchase.
A rise in the price level also means that the value of money is now lower because
each dollar
now buys a smaller quantity of goods and services.
If P is the price level,
then the quantity of goods and services that can be purchased with $1
is equal to 1/P.
The value of money is determined by
the supply and demand for money.
For the most part, the supply of money is determined by the Fed.
This implies that the quantity of money supplied is fixed (until the Fed changes it).

b. Thus, the supply of money will be vertical (perfectly inelastic).

The higher prices are,
the more money that is needed to perform transactions.
In the long run, the overall price level adjusts to the level at which the demand for money
equals the supply of money.
If the price level is above the equilibrium level,
people will want to hold more money
than is available and prices will have to decline.
If the price level is below equilibrium,
people will want to hold less money than that
available and the price level will rise.
Assume that the economy is currently in equilibrium and the Fed suddenly increases the
supply of money.
2. The supply of money shifts to the right.
3. The equilibrium value of money falls and the price level rises.
When an increase in the money supply makes dollars more plentiful,
the result is an increase
in the price level that makes each dollar less valuable.
quantity theory of money
a theory asserting that the quantity of
money available determines the price level and that the growth rate in the
quantity of money available determines the inflation rate.
People try to get rid of this excess supply in a variety of ways.
They may buy goods and services with the excess funds.
b. They may use these excess funds to make loans to others by buying bonds or depositing
the money in a bank account. These loans will then be used to buy goods and services.
c. In either case, the increase in the money supply leads to an increase in the demand for
goods and services.
d. Because the supply of goods and services has not changed, the result of an increase in
the demand for goods and services will be higher prices.
nominal variables
variables measured in monetary units.
real variables:
variables measured in physical units.
Prices in the economy are nominal (because they are quoted in units of money), but relative
prices
are real (because they are not measured in money terms).
monetary neutrality
the proposition that changes in the money
supply do not affect real variables.
velocity of money
the rate at which money changes hands.
To calculate velocity
we divide nominal GDP by the quantity of money.

velocity = nominal GDP/money supply

If P is the price level (the GDP deflator), Y is real GDP, and M is the quantity of money:
velocity = (P*Y)/M
Rearranging, we get the quantity equation:
M*V = P*Y
quantity equation:
the equation M × V = P × Y, which relates the
quantity of money, the velocity of money, and the dollar value of the economy’s
output of goods and services.
The quantity equation shows that an increase in the quantity of money must be reflected
in one of the other three variables.
Specifically, the price level must rise, output must rise, or velocity must fall.
Thus, when the central bank increases the money supply rapidly,
the result is a high level
of inflation.
Hyperinflation is generally defined as
inflation that exceeds 50% per month.
inflation tax
the revenue the government raises by creating money
The Fisher Effect
nominal interest rate = real interest rate + inflation rate
Growth in the money supply determines
the inflation rate.
The Fisher effect does not hold in the short run to the extent that
inflation is
unanticipated.
shoeleather costs:
the resources wasted when inflation encourages
people to reduce their money holdings.
menu costs
the costs of changing prices.
This implies that higher inflation will tend to
discourage saving
All societies experience short-run economic fluctuations around long-run trends
When recessions do occur, real GDP and other measures of
income, spending, and production fall, and unemployment rises.
The aggregate-demand curve slopes downward for three reasons.
The first is the wealth effect: A
lower price level raises the real value of households’ money holdings, which stimulates consumer
spending. The second is the interest-rate effect: A lower price level reduces the quantity of money
households demand; as households try to convert money into interest-bearing assets, interest rates
fall, which stimulates investment spending. The third is the exchange-rate effect: As a lower price
level reduces interest rates, the dollar depreciates in the market for foreign-currency exchange,
which stimulates net exports.
The long-run aggregate-supply curve is vertical.
In the long run, the quantity of goods and services
supplied depends on the economy’s labor, capital, natural resources, and technology, but not on the
overall level of prices.
According to the sticky-wage theory
an unexpected fall in the price level temporarily raises
real wages, which induces firms to reduce employment and production.
According to the sticky-price
theory,
an unexpected fall in the price level leaves some firms with prices that are temporarily too
high, which reduces their sales and causes them to cut back production.
Events that alter the economy’s ability to produce output, such as changes in labor, capital, natural
resources, or technology, shift
the short-run aggregate-supply curve (and may shift the long-run
aggregate-supply curve as well). In addition, the position of the short-run aggregate-supply curve
depends on the expected price level.
recession
a period of declining real incomes and rising unemployment.
depression
a severe recession.
Real GDP is the variable that is most often used to examine
short-run changes in the
economy.
When firms choose to produce a smaller amount of goods and services,
they lay off workers,
which increases the unemployment rate.
model of aggregate demand and aggregate supply:
the model that
most economists use to explain short-run fluctuations in economic activity around
its long-run trend.
aggregate-demand curve:
a curve that shows the quantity of goods
and services that households, firms, and the government want to buy at each
price level
aggregate-supply curve
a curve that shows the quantity of goods
and services that firms choose to produce and sell at each price level.
The Price Level and Consumption: The Wealth Effect
a. A decrease in the price level raises the real value of money and makes consumers feel
wealthier, which in turn encourages them to spend more.
b. The increase in consumer spending means a larger quantity of goods and services
demanded.
When the price level falls
households try to reduce their holdings of money by lending
some out (either in financial markets or through financial intermediaries).
Why the Aggregate-Demand Curve Might Shift
Shifts Arising from Changes in Consumption
a. If Americans become more concerned with saving for retirement and reduce current
consumption, aggregate demand will decline.
b. If the government cuts taxes, it encourages people to spend more, resulting in an
increase in aggregate demand.
Why the Aggregate-Demand Curve Might Shift
Shifts Arising from Changes in Investment
a. Suppose that the computer industry introduces a faster line of computers and many firms
decide to invest in new computer systems. This will lead to an increase in aggregate
demand.
b. If firms become pessimistic about future business conditions, they may cut back on
investment spending, shifting aggregate demand to the left.
c. An investment tax credit increases the quantity of investment goods that firms demand,
which results in an increase in aggregate demand.
d. An increase in the supply of money lowers the interest rate in the short run. This leads to
more investment spending, which causes an increase in aggregate demand.
Why the Aggregate-Demand Curve Might Shift
Shifts Arising from Changes in Government Purchases
a. If Congress decides to reduce purchases of new weapon systems, aggregate demand will
fall.
b. If state governments decide to build more highways, aggregate demand will shift to the
right.
Why the Aggregate-Demand Curve Might Shift
Shifts Arising from Changes in Net Exports
a. When Europe experiences a recession, it buys fewer American goods, which lowers net
exports at every price level. Aggregate demand will shift to the left.
b. If the exchange rate of the U.S. dollar increases, U.S. goods become more expensive to
foreigners. Net exports fall and aggregate demand shifts to the left.
Why the Aggregate-Supply Curve Is Vertical in the Long Run
2. Because the price level does not affect these determinants of output in the long run, the
long-run aggregate-supply curve is vertical.
3. The vertical long-run aggregate-supply curve is a graphical representation of the classical
theory.
Why the Long-Run Aggregate-Supply Curve Might Shift
The position of the aggregate-supply curve occurs at an output level sometimes referred to
as potential output or full-employment output.
natural rate of output:
the production of goods and services that an
economy achieves in the long run when employment is at its natural level.
Why the Long-Run Aggregate-Supply Curve Might Shift
Shifts Arising from Changes in Labor
a. Increases in immigration increase the number of workers available. The long-run
aggregate-supply curve would shift to the right.
b. Any change in the natural rate of unemployment will alter long-run aggregate supply as
well
Why the Long-Run Aggregate-Supply Curve Might Shift
Shifts Arising from Changes in Capital
a. An increase in the economy’s capital stock raises productivity and thus shifts long-run
aggregate supply to the right.
b. This would also be true if the increase occurred in human capital rather than physical
capital.
Why the Long-Run Aggregate-Supply Curve Might Shift
Shifts Arising from Changes in Natural Resources
a. A discovery of a new mineral deposit increases long-run aggregate supply.
b. A change in weather patterns that makes farming more difficult shifts long-run aggregate
supply to the left.
c. A change in the availability of imported resources (such as oil) can also affect long-run
aggregate supply.
Why the Long-Run Aggregate-Supply Curve Might Shift
Shifts Arising from Changes in Technological Knowledge
a. The invention of the computer has allowed us to produce more goods and services from
any given level of resources. As a result, it has shifted the long-run aggregate-supply
curve to the right.
b. Opening up international trade has similar effects to inventing new production processes.
Therefore, it also shifts the long-run aggregate-supply curve to the right.
Two important forces that govern the economy in the long run are technological progress
and monetary policy.
a. Technological progress shifts long-run aggregate supply to the right.
b. The Fed increases the money supply over time, which raises aggregate demand.
Why the Aggregate-Supply Curve Slopes Upward in the Short Run
The Sticky-Wage Theory
a. Nominal wages are often slow to adjust to changing economic conditions due to longterm
contracts between workers and firms along with social norms and notions of
fairness that influence wage setting and are slow to change over time.
b. Example: Suppose a firm has agreed in advance to pay workers an hourly wage of $20
based on the expectation that the price level will be 100. If the price level is actually 95,
the firm receives 5% less for its output than it expected and its labor costs are fixed at
$20 per hour.
c. Production is now less profitable, so the firm hires fewer workers and reduces the
quantity of output supplied.
d. Nominal wages are based on expected prices and do not adjust immediately when the
actual price level differs from what is expected. This makes the short-run aggregate supply
curve upward sloping.
Why the Aggregate-Supply Curve Slopes Upward in the Short Run
The Sticky-Price Theory
a. The prices of some goods and services are also sometimes slow to respond to changing
economic conditions. This is often blamed on menu costs.
b. If the price level falls unexpectedly, and a firm does not change the price of its product
quickly, its relative price will rise and this will lead to a loss in sales.
c. Thus, when sales decline, firms will produce a lower quantity of goods and services.
d. Because not all prices adjust instantly to changing conditions, an unexpected fall in the
price level leaves some firms with higher-than-desired prices, which depress sales and
cause firms to lower the quantity of goods and services supplied.
Why the Aggregate-Supply Curve Slopes Upward in the Short Run
The Misperceptions Theory
a. Changes in the overall price level can temporarily mislead suppliers about what is
happening in the markets in which they sell their output.
b. As a result of these misperceptions, suppliers respond to changes in the level of prices
and thus, the short-run aggregate-supply curve is upward sloping.
c. Example: The price level falls unexpectedly. Suppliers mistakenly believe that as the price
of their product falls, it is a drop in the relative price of their product. Suppliers may then
believe that the reward of supplying their product has fallen, and thus they decrease the
quantity that they supply. The same misperception may happen if workers see a decline
in their nominal wage (caused by a fall in the price level).
d. Thus, a lower price level causes misperceptions about relative prices, and these
misperceptions lead suppliers to respond to the lower price level by decreasing the
quantity of goods and services supplied.
All three theories suggest that output deviates in the short run from its long-run level when
the actual price level deviates from the expected price level.
quantity of output = natural rate of output + a (actual price level – expected price level)
Why the Short-Run Aggregate-Supply Curve Might Shift
Events that shift the long-run aggregate-supply curve will shift the short-run aggregatesupply
curve as well.

However, expectations of the price level will affect the position of the short-run aggregatesupply
curve even though it has no effect on the long-run aggregate-supply curve.

A higher expected price level decreases the quantity of goods and services supplied and
shifts the short-run aggregate-supply curve to the left. A lower expected price level increases
the quantity of goods and services supplied and shifts the short-run aggregate-supply curve
to the right.

According to classical theory,
changes in the quantity of money affect nominal variables
such as the price level, but not real variables such as output.
How Monetary Policy Influences Aggregate Demand
A. The aggregate-demand curve is downward sloping for three reasons.
1. The wealth effect.
2. The interest-rate effect.
3. The exchange-rate effect.
B. All three effects occur simultaneously, but are not of equal importance.
1. Because a household’s money holdings are a small part of total wealth, the wealth effect is
relatively small.
2. Because imports and exports are a small fraction of U.S. GDP, the exchange-rate effect is
also fairly small for the U.S. economy.
3. Thus, the most important reason for the downward-sloping aggregate-demand curve is the
interest-rate effect.
theory of liquidity preference:
Keynes’s theory that the interest rate
adjusts to bring money supply and money demand into balance.
The Theory of Liquidity Preference
This theory is an explanation of the supply and demand for money and how they relate to
the interest rate.
Money Demand
Any asset’s liquidity refers to the ease with which that asset can be converted into a
medium of exchange. Thus, money is the most liquid asset in the economy.
In the long run, the economy’s level of output, the interest rate, and the price level are
determined by the following manner:
a. Output is determined by the levels of resources and technology available.
b. For any given level of output, the interest rate adjusts to balance the supply and demand
for loanable funds.
c. Given output and the interest rate, the price level adjusts to balance the supply and
demand for money. Changes in the supply of money lead to proportionate changes in the
price level.
In the short run, the economy’s level of output, the interest rate, and the price level are
determined by the following manner:
The price level is stuck at some level (based on previously formed expectations) and is
unresponsive to changes in economic conditions.
b. For any given price level, the interest rate adjusts to balance the supply and demand for
money.
c. The interest rate that balances the money market influences the quantity of goods and
services demanded and thus the level of output.
The Downward Slope of the Aggregate-Demand Curve
When the price level increases, the quantity of money that people need to hold becomes
larger. Thus, an increase in the price level leads to an increase in the demand for money,
shifting the money demand curve to the right.

This implies that as the price level increases, the quantity of goods and services demanded
falls. This is Keynes’s interest-rate effect.

fiscal policy
: the setting of the level of government spending and taxation
by government policymakers.
When the government changes the level of its purchases,
it influences aggregate demand
directly. An increase in government purchases shifts the aggregate-demand curve to the
right, while a decrease in government purchases shifts the aggregate-demand curve to the
left.
The Multiplier Effect
Suppose that the government buys a product from a company.
a. The immediate impact of the purchase is to raise profits and employment at that firm.
b. As a result, owners and workers at this firm will see an increase in income, and will
therefore likely increase their own consumption.
c. Thus, total spending rises by more than the increase in government purchases.
multiplier effect
the additional shifts in aggregate demand that result
when expansionary fiscal policy increases income and thereby increases
consumer spending.
marginal propensity to consume (MPC ) is the
fraction of extra income that a
household consumes rather than saves.
The government spends $20 billion on new planes. Assume that MPC = 3/4.
Incomes will increase by $20 billion, so consumption will rise by MPC × $20 billion. The
second increase in consumption will be equal to MPC × (MPC × $20 billion) or MPC 2
×
$20 billion.
Multiplier = (1 + MPC + MPC2
+ MPC3
+ . . .).
Multiplier = (1 + MPC + MPC2
+ MPC3
+ . . .).
multiplier 1/(1 )
multiplier 1/(1 )
crowding-out effect:
the offset in aggregate demand that results when
expansionary fiscal policy raises the interest rate and thereby reduces investment
spending.
If consumers want to purchase more goods and services,
they will need to increase their
holdings of money. This shifts the demand for money to the right, pushing up the interest
rate
automatic stabilizers
changes in fiscal policy that stimulate aggregate
demand when the economy goes into a recession without policymakers having to
take any deliberate action.
The most important automatic stabilizer is the tax system.
a. When the economy falls into a recession, incomes and profits fall.
b. The personal income tax depends on the level of households’ incomes and the corporate
income tax depends on the level of firm profits.
c. This implies that the government’s tax revenue falls during a recession. This tax cut
stimulates aggregate demand and reduces the magnitude of this economic downturn.
Government spending is also an automatic stabilizer.
a. More individuals become eligible for transfer payments during a recession.
b. These transfer payments provide additional income to recipients, stimulating spending.
c. Thus, just like the tax system, our system of transfer payments helps to reduce the size
of short-run economic fluctuations.
Suppose that the money supply increases. In the short run, this increases prices according to
both the short-run Phillips curve and the aggregate demand and aggregate supply model.
Your boss gives you an increase in the number of dollars you earn per hour. This increase in pay makes
your nominal wage increase. If your nominal wage rose by a greater percentage than the price level, then
your real wage also increased.
Which of the following are costs incurred by people trying to protect themselves from the effects of inflation?
menu costs and shoeleather costs
In a certain economy, when income is $1000, consumer spending is $800. The value of the multiplier for this
economy is 2.5. It follows that, when income is $1020, consumer spending is
$812. For this economy, an initial increase of $100 in consumer spending translates into a $250 increase
in aggregate demand.
Suppose stock prices rise. To offset the resulting change in output the Federal Reserve could
decrease the money supply. This decrease would also move the price level closer to its value before the
rise in stock prices.
When the money supply decreases
interest rates rise and so aggregate demand shifts left.

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