10Chapter-Mankiw

10Chapter-Mankiw - CHAPTER 10 Aggregate Demand I Questions...

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Questions for Review 1. The Keynesian cross tells us that fiscal policy has a multiplied effect on income. The reason is that according to the consumption function, higher income causes higher con- sumption. For example, an increase in government purchases of G raises expenditure and, therefore, income by G . This increase in income causes consumption to rise by MPC ×∆ G , where MPC is the marginal propensity to consume. This increase in con- sumption raises expenditure and income even further. This feedback from consumption to income continues indefinitely. Therefore, in the Keynesian-cross model, increasing government spending by one dollar causes an increase in income that is greater than one dollar: it increases by G /(1 – MPC ). 2. The theory of liquidity preference explains how the supply and demand for real money balances determine the interest rate. A simple version of this theory assumes that there is a fixed supply of money, which the Fed chooses. The price level P is also fixed in this model, so that the supply of real balances is fixed. The demand for real money balances depends on the interest rate, which is the opportunity cost of holding money. At a high interest rate, people hold less money because the opportunity cost is high. By holding money, they forgo the interest on interest-bearing deposits. In contrast, at a low interest rate, people hold more money because the opportunity cost is low. Figure 10–1 graphs the supply and demand for real money balances. Based on this theory of liquidity preference, the interest rate adjusts to equilibrate the supply and demand for real money balances. 82 Supply of real money balances L (r) Demand for real money balances = M/P M/P Real money balances r r Interest rate Figure 10–1 CHAPTER 10 Aggregate Demand I
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Why does an increase in the money supply lower the interest rate? Consider what happens when the Fed increases the money supply from M 1 to M 2 . Because the price level P is fixed, this increase in the money supply shifts the supply of real money bal- ances M/P to the right, as in Figure 10–2. The interest rate must adjust to equilibrate supply and demand. At the old interest rate r 1 , supply exceeds demand. People holding the excess supply of money try to con- vert some of it into interest-bearing bank deposits or bonds. Banks and bond issuers, who prefer to pay lower interest rates, respond to this excess supply of money by lower- ing the interest rate. The interest rate falls until a new equilibrium is reached at r 2 . 3. The IS curve summarizes the relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services. Investment is negatively related to the interest rate. As illustrated in Figure 10–3, if the interest rate rises from r 1 to r 2 , the level of planned investment falls from I 1 to I 2 .
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10Chapter-Mankiw - CHAPTER 10 Aggregate Demand I Questions...

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