Monetary and Fiscal Policy on Aggregate Demand

Flashcards about the influence of monetary and fiscal policy on aggregate demand.

How does the interest-rate effect explain the aggregate-demand curve?

It helps explain the slope of the aggregate-demand curve.

How can the central bank use monetary policy to shift the AD curve?

By conducting open market operations to change the money supply.

In what two ways does fiscal policy affect aggregate demand?

Through the multiplier effect and the crowding-out effect.

What is a major debate regarding the use of monetary and fiscal policy?

Whether to use policy to try to stabilize the economy.

What are the three reasons why the AD curve slopes downward?

Wealth effect, interest-rate effect, and exchange-rate effect.

What is the Theory of Liquidity Preference?

A simple theory of the interest rate, denoted as 'r'.

What does money demand reflect?

It reflects how much wealth people want to hold in liquid form.

What variables influence money demand?

Real income (Y), interest rate (r), and price level (P).

What happens to money demand if real income (Y) rises?

An increase in real income (Y) causes an increase in money demand, other things equal.

What happens to money demand if the interest rate (r) rises?

An increase in the interest rate (r) causes a decrease in money demand, other things equal.

What happens to money demand if the price level (P) rises?

An increase in the price level (P) causes an increase in money demand, other things equal.

In the model of money supply and money demand, what is assumed about the money supply (MS)?

The quantity of money is fixed by the Federal Reserve.

How does a fall in the price level affect aggregate demand, according to the interest-rate effect?

A fall in price level (P) reduces money demand, which lowers the interest rate (r), which increases investment and the quantity of goods and services demanded.

How can the Federal Reserve raise the interest rate (r)?

By reducing the money supply.

If Congress cuts government spending, how should the Federal Reserve adjust money supply and interest rates to stabilize output?

Increase the money supply and reduce interest rates.

If a stock market boom increases household wealth, how should the Federal Reserve adjust money supply and interest rates to stabilize output?

Reduce money supply and increase interest rates.

If war breaks out in the Middle East, causing oil prices to soar, how should the Federal Reserve adjust money supply and interest rates to stabilize output?

Increase money supply and reduce interest rates.

What is a liquidity trap?

A situation where monetary policy may not work because nominal interest rates cannot be reduced further.

What is fiscal policy?

The setting of the level of government spending and taxation by government policymakers.

What is expansionary fiscal policy?

An increase in government spending and/or decrease in taxes.

What is contractionary fiscal policy?

A decrease in government spending and/or increase in taxes.

What is the multiplier effect?

The additional shifts in AD that result when fiscal policy increases income and thereby increases consumer spending.

What is the marginal propensity to consume (MPC)?

The fraction of extra income that households consume rather than save.

What is the crowding-out effect?

Fiscal expansion raises the interest rate, which reduces investment, which reduces the net increase in aggregate demand.

How does fiscal policy affect aggregate supply?

The short-run effects mainly work through aggregate demand, but it might also affect aggregate supply.

What are automatic stabilizers?

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

What are some examples of automatic stabilizers?

The tax system and government spending.