Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand

    In developing a theory of short run economic fluctuation, Keynes proposed the theory of liquidity preference to explain the determinants of the interest. According to this theory, the interest rate adjusts to balance the supply and demand for money.

    An increase in the price level raises money demand and increases the interest rate that bring the market into equilibrium. Since the interest rate represents the costs of borrowing, a higher interest rate reduces investment and quantity of goods and services demanded.

    Policymakers can influence aggregate demand with monetary policy, as an increase nion the money supply reduces the equilibrium interest rate for any given price. Since a lower interest rate stimulates investment spending, the aggregate demand curve shifts to the right. Fiscal policy could also be utilized to influence aggregate demand. Increases in government purchases of cuts in taxes shifts the demand curve to the right, whereas a decrease in government purchases or increase in taxes shifts the aggregate demand curve to the left.

When the government alters spending or taxes, the resulting shift in demand can be larger or smaller than the fiscal change, and the multiplier effect tends to amplify the effects of fiscal policy on aggregate demand. But, the bow dining out effect tends to dampen the effects of fiscal policy on aggregate demand.

Since monetary and fiscal policy can influence aggregate demand, the government sometimes uses these policy instruments in an attempt to stabilize the economy. Economists disagree about how active the government should be in this. According to advocates of active stabilization policy, changes in attitudes byu households and firms shift aggregate demand, but if the government does not respond, the result is undesirable and unnecessary fluctuations in output employment. According to critics of active stabilization policy, monetary and fiscal policy work with such long lags that attempts at stabilizing the economy often end up destabilizing it.

   

Chapter 33: Aggregate Demand and Aggregate Supply

Chapter 33 is about aggregate supply and aggregate demand. The model is used to explain short-run fluctuations in economic activity around its long run trend. The aggregate demand curve shows the quantity of food and services that households, firms, the government, and customers abroad want to buy at each price level, and the supply curve is the quantity of goods and services that firms choose to produce and sell at each price level.

Short run fluctuations are unpredictable, and these recessions cause real GDP as well as income, spending, and production falls, and unemployment rises. According to the model, the output of goods and services and overall level of prices adjust to balance aggregate demand and supply. The aggregate demand curve slopes downward because of the wealth effect, the interest rate effect, and the exchange rate effect. The wealth effect states that a lower price level raises the real value of household money holdings, stimulating consumer spending. The interest effect states that a lower price level reduces the quantity of money demanded, and as households convert money into interest bearing assets, interest rates fall, stimulating investment spending. The exchange rate effect states that as a lower price level reduces interest rates, the dollar depreciates, stimulating net exports.

Aggregate demand could be affected by any event or policy that raises consumption, investment, government purchases, or net exports at a given price level.

Long run aggregate supply is vertical; the quantity of goods and services supplied depends on the economy’s labor, capital, natural resources, and technology.

Chapter 32: A Macroeconomic Theory of the Open Economy

Chapter 32 talks about the supply and demand for loanable funds and foreign currency exchange. Supply and demand is balanced by the real exchange rate in foreign currency exchanges. Since net capital outflow is part of demand for loanable funds and supplies the foreign currency exchange, it connects the two markets.

Two markets are central to the macroeconomics of open economies, which are the market for loanable funds and the market for foreign currency exchange. In the market for loanable funds, the real interest rate adjust to balance the supply of loanable funds (from national saving) and the demand for loanable funds (from domestic investment and net capital outflow). The real exchange rate adjust to balance the supply and the demand for dollars in the market for currency exchange. Furthermore, since net capital outflow is part of the demand for loanable funds and the supply for the foreign currency exchange, it connects the two markets.

A policy that reduces national saving such as a government budget deficit reduces the supply of loanable funds and increases interest rate. More interest rate leads to a smaller amount of net capital outflow, reducing the supply of dollars in the market for foreign currency exchange. The dollar therefore appreciates and net exports fall.

Restrictive trade policies are sometimes advocated to alter the trade balance, they do not always have that effect, A trade restriction increases net exports for a given exchange rate and,m therefore, increases the demand for dollars in the market for foreign currency exchange. An a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods.

When investors change their attitudes towards holding assets in a country, the effects on the economy can be profound, Political instability can lead to capital flight, increasing interest rates and depreciating the currency.

Chapter 31: The Macroeconomics of Open Market Operations

Chapter 31 talks about the macroeconomics in open economies. Part of these include the market of loanable funds and the market of currency exchanges. Furthermore, trade policy and budget deficits are taken into account.

The two markets central to the macroeconomics of open economies are the market for loanable funds and the market for foreign currency exchange. In the market for loanable funds, the interest rate changes to balance the supply of funds and the demand for funds, coming from national saving and investment, respectively. In the market for foreign currency exchange, the real exchange rate adjusts to balance the supply and demand for dollars. Since net foreign investment is part of the demand for loanable funds and provides the supply of dollars for exchange, it is the variable connecting the two markets.

Trade policies could help reduce national saving. Policies like this, such as government budget deficits, reduce the supply of loanable funds, increasing the interest rate. The higher the interest rate, the lower the net foreign investment, reducing the supply of dollars in the market for foreign currency exchange. The dollar gains values, and exports fall.

Restrictive trade policies such as tariffs or import quotas are shown to alter the trade balance, but do not always have that effect. Trade restrictions increase net exports and demand for dollars in the market for foreign currency exchange. Therefore, the dollar gains more value, making domestically produced goods more expensive. However, the increase in value offsets the impact of trade restriction on net exports.

Chapter 30: Money Growth and Inflation

Chapter 29 is about the causes and costs of inflation (whose primary cause is the increase in amount of money in circulation). More money, more problems. Therefore, in order to maintain stable prices, the central bank must have strict control over the amount of money in circulation, so as not to cause inflation. The overall level of prices in an economy adjusts to bring money supply and money demand into balance., When the central bank increases the supply of money, it causes the price level to rise. Persistent growth in the quantity of money supplied leads to inflation.

The principle of monetary neutrality says that changes in the quantity of money influence nominal but no real variables, also, most economists believe that monetary neutrality describes the economic behavior in the long run.

A government can pay for its spending by printing money, which leads to an inflation tax. This can lead to hyperinflation.

The Fisher Effect is an application of the principle of monetary neutrality because when the inflation rate rises, the nominal interest rate rises by the same amount.

Many people think that inflation makes them poorer but inflation not only increases the cost of what they buy but also the nominal incomes.

There are six costs on inflation shoeleather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities due to non indexation of the tax code, confusion, and inconvenience resulting from a changing unit of account.

Chapter 28: Unemployment

Chapter 28 is all about employment and how it is measured, what types exist, and the reason for its existence. The economy’s natural rate of unemployment is the amount of unemployment that the economy normally experiences. There are three kinds of workers: employed, unemployed, and not in labor force. Employed refers to paid employees, both full time and past time. Unemployed workers are people who were once available for work and have tried finding employment. People not in the labor force are neither looking for a job or employed. Discouraged workers are also people who would have liked to work, but have given up looking for a job, so therefore have been eliminated from the labor force.

The labor force consists of employed and unemployed added together, and the unemployment rate is the number of unemployed divided by the labor force times 100. The labor force participation rate is the labor force divided by the adult population times 100.

There are two kinds of unemployment: frictional and structural. Frictional employments is employment that comes from workers taking time to search for jobs best suitable to their interests. Structural unemployment that unemployment hat results from lack of available jobs in the market. Job search is the process by which workers find appropriate jobs given their tastes and skills.

Unemployment insurance is a government program that partially protects workers’ incomes when they become unemployed, explaining why people could be not considered to be part of the labor force. People respond to incentives, so they no longer look for a job because they are still getting paid.

Chapter 27: The Basic Tools of Finance

Chapter 27 studies the basic tools of finance, defined as the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk. The time value of money has two values: present and future value. Present value is the amount of money needed to produce another amount of money in the future. Future value is the amount of money that an amount of money today would yield, if interest rates remain constant. This can be calculated through compounding, which is the accumulation of a sum in money where the interest earned remains in the account to accumulate more interest.

Risks are other tools of finance, which explains insurance, diversification, and the risk-return trade-off, especially when risk aversion is involved, which is a dislike of uncertainty. Insurance is based off of risk, when people decide whether or not to take the risk of paying for insurance when it is possible nothing would happen, but the insurance market spreads risks. However, adverse selection and moral hazard prevent the risk from being properly spread because people would behave more carelessly and would not consider insurance if they are low risk.

Diversification is the reduction of risk by replacing a single risk with a large number of unrelated risks. An example is a stock portfolio, where savers would spend money on multiple unrelated stocks rather than a single stock. Diversification eliminated firm-specific risk which is a risk that affects only a single company, but cannot avoid market risk, which is a risk that affects all companies.

Asset valuation is the last basic tool of finance, a big part of it being fundamental analysis. People would study a company’s accounting statements and future prospects to determine its value, and if the price is less than the value, the stock is undervalued, where as if the price is more than the value, the stock is overvalued.

The efficient markets hypothesis is the theory that asset prices reflect all publicly available information about the value of an asset. Information efficiency is the description of asset prices that rationally reflect all available information, and random walks are the paths of a variable whose changes cannot be predicted.