Chapter 34

Chapter 34 is about monetary and fiscal policy and their effects on the aggregate demand curve. Out of the three reasons that the aggregate demand is downward sloping, the interest-rate effect is the most important reason. The interest rate effect, as explained in the previous chapter, is that a lower price level reduces the amount of money people want to hold. The theory of liquidity preference is that the interest rate adjusts to the money supply and money demand's equilibrium. The two pieces of the theory of liquidity preference is money supply and money demand. Money supply is controlled by the Federal Reserve, who then alters the supply with the buying and selling of government bonds in open market operations. When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any price level, shifting the aggregate demand curve right. The inverse situation of this is also true. Fiscal policy is the determining of the level of government spending and taxation by policymakers. The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy increases income, which then increases consumer spending. The marginal propensity to consume (MPC) is the fraction of extra income that a household consumes rather than saves. The Multiplier equation is Multiplier=1+MPC+MPC^2+MPC^3... When x=MPC then the equation can be simplified to Multiplier= 1/(1-MPC). The larger the MPC, the greater effect on consumption, and the larger the multiplier. The crowding out effect is when expansionary fiscal policy raises the interest rate, which then reduces investment spending, creating a reduction in aggregate demand. Economic stabilization has been a clear goal of the United States policy since the Employment Act of 1946.