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Theory of Liquidity Preference:
- simple theory of the interest rate (denoted by r) where r adjusts to balance the supply and demand for money
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In the theory of liquidy preference, what should be assumed about the money supply?
assume it fixed by the central bank and it doesn't depend on interest rate
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What does money demand relfect about people?
it shows how much money people want to hold in liquid form
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In simple terms, what two assets does a household have?
- Money (liquid but pays no interest)
- Bonds (not liquid but pays interest)
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What does a household's money demand reflect?
it's preference for liquidity
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What variables influence money demand?
Y, r, and P
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If Y rises in the Theory of Liquidity Preference:
households want to buy more things, so they need more money and attempt to sell their bonds, increaseing money demand
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when the money supply curve is vertical, do changes to r affect the money supply?
no
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When the money demand curve goes downwards, what does a change in r do?
increase money demand
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in order to change the interest rate AND shift the AD curve, what does the Fed do?
they conduct open market operations
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when prices drop, interest rates drops; creates more or less incentive to buy more goods?
MORE
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when interest rates drop, ______ __ ____ demanded AND __ increases
quantity of goods; I
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liquidity trap:
when the interest rate is close to 0
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fiscal policy:
the setting of the level of govt spending and taxation by govt policymakers
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Expansionary fiscal policy:
an increase in G and/or decrease in T; shifts the AD right
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Contractionary fiscal policy:
a decrease in G and/or increase in T; shifts AD left
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multiplier effect:
the additional shifts in AD that result when fiscal policy increases income and thereby increases consumer spending
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Marginal propensity to consume (MPC):
the fraction of extra income that households consume rather than save
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crowding out effect:
when the gov spends, they get their money from taxes or borrowing, causing interest rates to go up
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tax cuts ______ household's take-home pay and spending
increase
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the size of the tax cut shift is affected by what 2 effects?
the multiplier effect and crowding-out effect
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what happens if the buyer doesn't feel safe about spending
then they won't spend
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Automatic stabilizers (fiscal policy tools):
gov spending and tax cuts
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what did Keynes say about how people's attitude changes the AD curve?
pessimism and optimism in households and firms cause shifts in the AD curve and fluctuations in output and employment
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what happens to money demand and interest rates when the gov borrows?
they increase
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what does an increase in money demand and interest rates do to the private sector?
people stop spending and small businesses stop hiring = crowding out effect
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what does an increase in Y do to the the money demand and interest rate?
increases it!
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contractionary monetary policy:
selling securities to decrease money supply and cause the interest rate to go higher. The AD declines.
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what do banks do when they want to increase the money supply?
they decrease the interest rate to make more incentive for consumers to buy more
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federal funds rate:
the rate banks charge each other when then borrow
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which way does the AD curve go when the interest rate rises?
left
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when the AD curve goes left, what does the Fed do to fix it? What does this cause?
increase money supply by buying bonds; interest rates drop so that consumption and investment goes up
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Crowding out effect only can be used to talk about the effects of what?
interest on the budget
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Fiscal policy has what kind of effect?
- indirect effect; you will either consume or save
- Y= C + S
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What goes up when gov takes away substitutions for the businesses?
cost of production and SRAS curve go up!
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Short run trade off between unemployment and inflation:
low inflation = high unemployment
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2 things to cause inflation:
increase AD, decrease SRAS
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What did Milton Friedman say about the Philips curve in the long run?
in the long run, the Philips curve will be vertical because we don't know where inflation will go in the short run because THERE ISN'T ENOUGH DATA. The long run will have enough data to know where inflation is and it will already be back and the normal unemployment rate
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Unemployment rate formula:
- Unemployment Rate = natural rate of unemp. – a(actual inflation - expected inflation)
- *a is coefficient
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Supply shock:
when there is a sudden large change in supply and it raises prices (like a sudden drop in SRAS)
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How do you control inflation?
contractionary monetary policy
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sacrifice ratio:
for every 1% inflation reduction, 5% output is give up
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rational expectation:
the cost of the inflation is actually less; people react a lot faster than the market adjusts
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what did Paul Walker use as federal reserve chairman in '70-'80s to bring inflation down?
use contractionary policy
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Greenspan era:
late 80's-early 2000; 1984-2005 was a period of low inflation/unemployment and high growth because the SRAS was increasing; oil dropped in price and productivity increased; GDP was growing really fast and wealth was increasing
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what cause of inflation will allow the Philips curve to work?
AD or inflation, not SRAS
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what caused the recent recession?
decrease in AD, higher unemployment and lower inflation
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