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Lec05handout - The Influence of Monetary and Fiscal Policy...

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The Influence of Monetary and Fiscal Policy on Aggregate Demand Slide #05 Intro Macro 1
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Monetary Policy Influences Aggregate Demand Aggregate-demand curve slopes downward: The wealth effect The interest-rate effect The exchange-rate effect Occur simultaneously: When price level falls Quantity of goods and services demanded increases When price level rises Quantity of goods and services demanded decreases Intro Macro 2
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Monetary Policy Influences Aggregate Demand For U.S. economy The wealth effect Least important Money holdings a small part of household wealth The exchange-rate effect Not large Exports and imports small fraction of GDP The interest-rate effect The most important Intro Macro 3
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Monetary Policy Influences Aggregate Demand The theory of liquidity preference Keynes’s theory Interest rate adjusts: To bring money supply and money demand into balance Nominal interest rate Real interest rate Intro Macro 4
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Monetary Policy Influences Aggregate Demand The theory of liquidity preference Money supply Controlled by the Fed Quantity of money supplied Fixed by Fed policy Doesn’t vary with interest rate Intro Macro 5
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Monetary Policy Influences Aggregate Demand The theory of liquidity preference Money demand Money most liquid asset Interest rate opportunity cost of holding money Money demand curve downward sloping Equilibrium in the money market Equilibrium interest rate Quantity of money demanded = quantity of money supplied Intro Macro 6
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Monetary Policy Influences Aggregate Demand The theory of liquidity preference If interest rate > equilibrium Quantity of money people want to hold Less than quantity supplied People holding the surplus Buy interest-bearing assets Lowers the interest rate People - more willing to hold money Until: equilibrium Intro Macro 7
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Monetary Policy Influences Aggregate Demand The theory of liquidity preference If interest rate < equilibrium Quantity of money people want to hold More than quantity supplied People - increase their holdings of money Sell - interest-bearing assets Increase interest rates Until: equilibrium Intro Macro 8
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Equilibrium in the money market 9 Interest rate Quantity of Money r 1 Money demand M d 1 According to the theory of liquidity preference, the interest rate adjusts to bring the quantity of money supplied and the quantity of money demanded into balance. If the interest rate is above the equilibrium level (such as at r 1 ), the quantity of money people want to hold (Md 1 ) is less than the quantity the Fed has created, and this surplus of money puts downward pressure on the interest rate. Conversely, if the interest rate is below the equilibrium level (such as at r 2 ), the quantity of money people want to hold (Md 2 ) is greater than the quantity the Fed has created, and this shortage of
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This document was uploaded on 10/28/2011 for the course 220 103 at Rutgers.

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Lec05handout - The Influence of Monetary and Fiscal Policy...

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