# Essentials of Economics Study Set 12

## Quiz 24 :The Influence of Monetary and Fiscal Policy on Aggregate Demand

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The economy is in a recession with high unemployment and low output. a. Draw a graph of aggregate demand and aggregate supply to illustrate the current situation. Be sure to include the aggregate-demand curve, the short-run aggregate-supply curve, and the long-run aggregate- supply curve. b. Identify an open-market operation that would restore the economy to its natural rate. c. Draw a graph of the money market to illustrate the effect of this open-market operation. Show the resulting change in the interest rate. d. Draw a graph similar to the one in part (a) to show the effect of the open-market operation on output and the price level. Explain in words why the policy has the effect that you have shown in the graph.
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a)
The diagrammatic representation of an economy experiencing recession is shown below:
Figure-1: Aggregate Demand and Aggregate Supply
In figure-1, AD is the aggregated demand curve, SRAS is the short-run aggregate supply curve and LRAS is the long-run aggregate supply curve respectively. The economy is at the equilibrium point E which represents a situation of recession because aggregate demand is too low that it leads to a low production, the output is below the natural level of output. The recessionary gap is represented by Q N -Q. Since the output level is below its natural level, there unemployment is high.
b)
In order to boost up the aggregate demand to restore the economy to its natural state, money supply in the economy can be increased. To increase money supply, the government can buy government securities from the public.
c)
The effect of open-market operation on the money market is shown in Figure 2.
Figure-2: Open-Market Operations in Money Market
The money supply curve shifts from MS to MS 1. The resulting impact on the rate of interest is that it falls from r to r 1.
d)
The effect of open-market operation on the economy is shown in figure 3.
Figure-3: Effect of Open Market Operations on Output and The Price Level
A fall in the interest rate results in an increase in the aggregate demand. The increase in the aggregate demand is shown in figure 3 by a shift in the AD curve to AD 1. In the shown scenario, the price level increases from P to P 1 and the aggregate demand has increased to such an extent that the economy is restored to its natural state, wherein the economy produces Q N level of output.

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Explain how each of the following developments would affect the supply of money, the demand for money, and the interest rate. Illustrate your answers with diagrams. a. The Fed's bond traders buy bonds in open-market operations. b. An increase in credit-card availability reduces the cash people hold. c. The Federal Reserve reduces banks' reserve requirements. d. Households decide to hold more money to use for holiday shopping. e. A wave of optimism boosts business investment and expands aggregate demand.
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a. When the Fed's bond traders buy bonds in open-market operations, the money -supply curve shifts to the right from MS 1 to MS 2. The result is a decline in the interest rate.
Change in Money supply
b. When an increase in credit card availability reduces the cash people hold, the money-demand curve shifts to the left from MD 1 to MD 2. The result is a decline in the interest rate. Graphically, this can be seen as below:
Change in Demand
c. When the Federal Reserve reduces reserve requirements, the money supply increases, so the money-supply curve shifts to the right from MS 1 to MS 2. The result is a decline in the interest rate. The figure is same as in (a)
d. When households decide to hold more money to use for holiday shopping, the money-demand curve shifts to the right from MD 1 to MD 2. The result is a rise in the interest rate.
Figure 3
e. When a wave of optimism boosts business investment and expands aggregate demand, money demand increases from MD 1 to MD 2 in Figure 3. The increase in money demand increases the interest rate. Graphically, this can be seen as below:
Figure 4

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The Federal Reserve expands the money supply by 5 percent. a. Use the theory of liquidity preference to illustrate in a graph the impact of this policy on the interest rate. b. Use the model of aggregate demand and aggregate supply to illustrate the impact of this change in the interest rate on output and the price level in the short run. c. When the economy makes the transition from its short-run equilibrium to its long-run equilibrium, what will happen to the price level? d. How will this change in the price level affect the demand for money and the equilibrium interest rate? e. Is this analysis consistent with the proposition that money has real effects in the short run but is neutral in the long run?
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a. The increase in the money supply will cause the equilibrium interest rate to decline. Households will increase spending and will invest in more new housing. Firms too will increase investment spending. This will cause the aggregate demand curve to shift to the right and it shows Quantity of output and Price level.
b. In the short run, the increase in aggregate demand will cause an increase in both output and the price level in the short run.
c. When the economy makes the transition from its short-run equilibrium to its long-run equilibrium, short-run aggregate supply will decline, causing the price level to rise even further.
d. The increase in the price level will cause an increase in the demand for money, raising the equilibrium interest rate.
e. Yes. While output initially rises because of the increase in aggregate demand, it will fall once short-run aggregate supply declines. Thus, there is no long-run effect of the increase in the money supply on real output.

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The Federal Reserve's target rate for the federal funds rate
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In the early 1980s, new legislation allowed banks to pay interest on checking deposits, which they could not do previously. a. If we define money to include checking deposits, what effect did this legislation have on money demand? Explain. b. If the Federal Reserve had maintained a constant money supply in the face of this change, what would have happened to the interest rate? What would have happened to aggregate demand and aggregate output? c. If the Federal Reserve had maintained a constant market interest rate (the interest rate on nonmonetary assets) in the face of this change, what change in the money supply would have been necessary? What would have happened to aggregate demand and aggregate output?
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With the economy in a recession because of inadequate aggregate demand, the government increases its purchases by $1,200. Suppose the central bank adjusts the money supply to hold the interest rate constant, investment spending is fixed, and the marginal propensity to consume is 2/3. How large is the increase in aggregate demand? Multiple Choice Answer: Tags Choose question tag An economy is operating with output$400 billion below its natural level, and fiscal policymakers want to close this recessionary gap. The central bank agrees to adjust the money supply to hold the interest rate constant, so there is no crowding out. The marginal propensity to consume is 4/5, and the price level is completely fixed in the short run. In what direction and by how much would government spending need to change to close the recessionary gap? Explain your thinking.
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If the central bank wants to expand aggregate demand, it can ________ the money supply, which would ________ the interest rate.
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Give an example of a government policy that acts as an automatic stabilizer. Explain why the policy has this effect.
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Consider two policies-a tax cut that will last for only one year and a tax cut that is expected to be permanent. Which policy will stimulate greater spending by consumers? Which policy will have the greater impact on aggregate demand? Explain.
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Suppose a computer virus disables the nation's automatic teller machines, making withdrawals from bank accounts less convenient. As a result, people want to keep more cash on hand, increasing the demand for money. a. Assume the Fed does not change the money supply. According to the theory of liquidity preference, what happens to the interest rate? What happens to aggregate demand? b. If instead the Fed wants to stabilize aggregate demand, how should it change the money supply? c. If it wants to accomplish this change in the money supply using open-market operations, what should it do?
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Which of the following is an example of an automatic stabilizer? When the economy goes into a recession,
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If the central bank in the preceding question instead holds the money supply constant and allows the interest rate to adjust, the change in aggregate demand resulting from the increase in government purchases will be
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Suppose the government reduces taxes by $20 billion, that there is no crowding out, and that the marginal propensity to consume is ¾. a. What is the initial effect of the tax reduction on aggregate demand? b. What additional effects follow this initial effect? What is the total effect of the tax cut on aggregate demand? c. How does the total effect of this$20 billion tax cut compare to the total effect of a $20 billion increase in government purchases? Why? d. Based on your answer to part (c), can you think of a way in which the government can increase aggregate demand without changing the government's budget deficit? Essay Answer: Tags Choose question tag If the government wants to contract aggregate demand, it can ________ government purchases or ________ taxes. Multiple Choice Answer: Tags Choose question tag The government spends$3 billion to buy police cars. Explain why aggregate demand might increase by more than $3 billion. Explain why aggregate demand might increase by less than$3 billion.
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Use the theory of liquidity preference to explain how a decrease in the money supply affects the aggregate-demand curve.
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What is the theory of liquidity preference? How does it help explain the downward slope of the aggregate-demand curve?
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Suppose economists observe that an increase in government spending of $10 billion raises the total demand for goods and services by$30 billion. a. If these economists ignore the possibility of crowding out, what would they estimate the marginal propensity to consume (MPC) to be? b. Now suppose the economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than their initial one?