Group B Discussion: Influences of Monetary and Fiscal Policy (Ch.34)

1. What is the theory of liquidity preference and how does it help explain the downward slope of the aggregate demand curve?

John Maynard Keynes came up with the theory of liquidity preference to explain short-term determination of an economy's interest rate. The interest rate adjusts to try to achieve equilibrium in the money market between the supply and demand of money. This is explained by the downward slope of the aggregate demand curve, which illustrates the negative relationship between the price level and the quantity of goods and services demanded. An increase in the price level causes an increase in the demand for money, and thus an increase in the interest rate as well. This reduces the quantity of goods and services demanded.

2. Use the liquidity preference theory to explain how decreases in the money supply affect the AD curve.

A decrease in the money supply causes a raise in the interest rate and reduces the quantity of goods and services demanded for any given price level. This shifts the aggregate demand curve to the left.

3. Give an example of a government policy that acts as an automatic stabilizer. Explain why the policy has this effect.

When the country falls into an economic recession, the government policy of collecting taxes, particularly personal income, payroll, and corporate income taxes, functions as an automatic stabilizer. A high amount of revenue from these taxes is tied to economic prosperity. The more people are paid, the more money companies earn, the higher the government's tax revenue. The short-term lower taxes stimulate aggregate demand and automatically help prevent severe economic fluctuations.