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Chapter 34Chapter 34 The Influence of Monetary and Fiscal Policy on Aggregate Demand WHAT’S NEW IN THE THIRD EDITION: The  Case Study  on "Why the Fed Watches the Stock Market (and Vice Versa)" has been updated. LEARNING OBJECTIVES: By the end of this chapter, students should understand: the theory of liquidity preference as a short-run theory of the interest rate. how monetary policy affects interest rates and aggregate demand. how fiscal policy affects interest rates and aggregate demand. the debate over whether policymakers should try to stabilize the economy. CONTEXT AND PURPOSE: Chapter 21 is the second chapter in a three-chapter sequence that concentrates on short-run fluctuations  in the economy around its long-term trend. In Chapter 20, the model of aggregate supply and aggregate  demand is introduced.  In Chapter 21, we see how the government’s monetary and fiscal policies affect  aggregate demand. In Chapter 22, we will see some of the tradeoffs between short-run and long-run  objectives when we address the relationship between inflation and unemployment. The purpose of Chapter 21 is to address the short-run effects of monetary and fiscal policies. In  Chapter 20, we found that when aggregate demand or short-run aggregate supply shifts, it causes  fluctuations in output. As a result, policymakers sometimes try to offset these shifts by shifting aggregate  demand with monetary and fiscal policy. Chapter 21 addresses the theory behind these policies and  some of the shortcomings of stabilization policy. 1
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 Chapter 34/The Influence of Monetary and Fiscal Policy on Aggregate Demand
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Chapter 34/The Influence of Monetary and Fiscal Policy on Aggregate Demand   3 KEY POINTS: 1. In developing a theory of short-run economic fluctuations, Keynes proposed the theory of liquidity  preference to explain the determinants of the interest rate.  According to this theory, the interest rate  adjusts to balance the supply and demand for money. 2. An increase in the price level raises money demand and increases the interest rate that brings the  money market into equilibrium.  Because the interest rate represents the cost of borrowing, a higher  interest rate reduces investment and, thereby, the quantity of goods and services demanded.  The  downward-sloping aggregate-demand curve expresses this negative relationship between the price  level and the quantity demanded.
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