Wednesday, March 11, 2009


1 What role do interest rates play according to the liquidity preference theory?

A)when the interest rate increases, the opportunity cost of money increases, so people hold less money
B) Equilibrium in the money market is achieved by adjustments in the interest rate

2 What determines the money supply according to liquidity preference theory? What happens if there is an increase in the money supply? What happens if there is a decrease in the money supply?

The federal reserve determines the money supply .

If the Federal Reserve increases the money supply the money supply curve will shift right and interest rates will decrease. The Aggregate Demand curve will also shift right. If the Federal Reserve decreases the money supply, the money supply curve will shift left and interest rates will increase. The Aggregate Demand curve will shift left.

3. What effect does an increase in government spending have on the aggregate demand curve?

An increase in government spending initially shifts the aggregate demand curve to the right.

4. Explain the multiplier effect. Give an example:

With the multiplier effect, additional shifts in aggregate demand result when expansionary fiscal policy (government spending or tax refund checks) increases income and thereby increases consumer spending. Graphically there is an initial shift from the initial government spending, then an additional shift from the increases in consumer spending.

Example: The government spends money on roads and schools. The owners of the construction companies pay their workers and more teachers are hired to teach. The workers and teachers increase their spending. The firms that the workers and teachers buy goods from increase their production. Spending and income continues to increase, much more than the initial money spent by the government.

5. How does the crowding out effect impact the an increase in government spending?

According to the crowding out effect, an increase in government spending increases the interest rate and decreases investment spending. Graphically the aggregate demand curve may initially shift outward, but then may shift back in. As a result, the impact of government spending on ‘stimulating’ economic activity is less.

Note: The net effect of fiscal policy is uncertain. The multiplier effect increases the effects of an increase in government expenditures while the crowding out effect diminishes the effect of government expenditures. Both effects work against each other.

6. How might a tax cut affect the short run aggregate supply curve?

If the government cuts the tax rate, workers keep more of each dollar they earn, so they work more The quantity of goods and services supplied will be greater at each price level. As a result the short run aggregate supply curve shifts to the right and output increases.

Further, the cut in tax rates will stimulate enough additional production and income that tax revenue actually increases.

7. What is stabilization policy?

Stabilization policy is an attempt by policymakers and the federal reserve to control aggregate demand and stabilize the economy.

Ex: if there is a decrease in aggregate demand due to consumer and investor pessimism, the aggregate demand curve may shift left. A recession may result.
To combat this, the federal reserve may increase the money supply, or the government may increase spending in order to ‘shift ‘ the aggregate demand curve back out . The purpose would be to promote economic recovery from the recession or prevent it.

8. Why are many economists critical of stabilization policy?

A. There is a lag between the time policy is passed and the time policy has an impact on the economy.

B. The impact of the policy may last longer than the problem it was designed to offset

C. Policy can be a source of, instead of a cure for, economic fluctuations

Ex: During the Great Depression stabilization policies may have increased its severity and prolonged the time it normally would have taken to recover.