Orange Brigade

Theory of Liquidity Preference- Keynes's Theory that Interest rate adjusts to bring Money Supply and demand into Balance 1. Money Supply- Fixed by Central Bank, unresponsive to interest rate 2. Money Demand- recall components that affect AD curve 3. Equilibrium in Money Market- If interest rate isn’t at equilibrium, people will buy or sell assets to drive market towards equilibrium. As real income rises, Households purchase more goods and services, so demand for money increases. Households sell bonds to increase money holdings Increase in IR increases cost of holding money. Therefore, quantity of money demanded decreases. Decreasing IR decreases cost of holding money, so money demand increases As a result, Money Demand curve slopes downwards

M Interest rate MS Quantity fixed by the Fed MD 1 r1r1 Determination of IR

Monetary Policy and Aggregate Demand Fed uses monetary policy to shift the aggregate Demand curve by altering the money supply. Recall that the Fed adjusts the interest rate by changing the Fed Funds Rate Fed uses Open Market operations to change the interest rate and to shift the AD curve

THE INFLUENCE OF MONETARY AND FISCAL POLICY 5 The Effects of Reducing the Money Supply Y P M Interest rate AD 1 MS 1 MD P1P1 Y1Y1 r1r1 MS 2 r2r2 AD 2 Y2Y2 The Fed can raise r by reducing the money supply. An increase in r reduces the quantity of g&s demanded.

Fiscal Policy- Setting of the level of government spending and taxation increase in government purchases or decrease in taxation Expansionary policies shift AD rightwards Contractionary policies shift AD leftwards decrease in government purchases or increase in taxation

Multiplier effect- additional shifts in AD resulting when fiscal policy increases income and thereby consumer spending. Increase in real income increases consumer spending, ` shifting AD rightwards Marginal Propensity to Consume- Fraction of extra income households consume rather than save  G is the change in G,  Y and  C are the ultimate changes in Y and C Y = C + I + G + NXidentity  Y =  C +  G I and NX do not change  Y = MPC  Y +  G because  C = MPC  Y solved for  Y 1 1 – MPC  Y = GG Formula for the multiplier:

Y P AD 1 P1P1 AD 2 AD 3 Y1Y1 The Multiplier Effect

Crowding-Out Effect is also affected by Fiscal Policy Expansionary policy increases interest rate, which reduces investment, which reduces the net increase in aggregate demand. So, the size of the AD shift may be smaller than the initial fiscal expansion.

Changes in Taxes Tax cuts increase take-home pay for households, increasing consumer spending and shifting AD to the right. If household perceives tax cut to be permanent, shift is larger.

Using policy to stabilize the economy Active stabilization- supporters of active stabilization believe it is the government’s responsibility to regulate the economy. Expansionary policy should be used during a recession, contractionary policy should be used during periods of rapid inflation Booms, recessions, and crashes cause fluctuations in the market Against Active stabilization- critics of active stabilization claim that monetary and fiscal policy affects economy with a long lag Because firms create investment plans in advance, investment takes time to respond to changes in IR Because government purchases and taxes require congressional approval, G and T require time These lags can destabilize the economy Automatic stabilizers- changes in fiscal policy that stimulate AD when economy goes into recession, without policymakers having to take any deliberate action Include tax system and government spending