7/31/2019 Economics For Managers GTU MBA Sem 1 Chapter 32
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By:
Prof. Sharif Memon
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The aggregate demand curve
slopes downward for threereasons:
The wealth effect
The interest-rate effect
The exchange-rate effect
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Keynes developed the theory of liquidity
preference in order to explain what
factors determine the economys interestrate.
According to the theory, the interest rate
adjusts to balance the supply anddemand for money.
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Money demand is determined by several
factors.
According to the theory of liquidity
preference, one of the most important
factors is the interest rate.
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Assume the following about the economy:
The price level is stuck at some level.
For any given price level, the interest rateadjusts to balance the supply and demand
for money.
The level of output responds to theaggregate demand for goods and services.
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Quantity ofMoney
InterestRate
0
Moneydemand
Quantity fixedby the RBI
Moneysupply
r2
Md
2
r1
M
d
1
Equilibrium
interest rate
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Y2
AD2
3. whichincreases thequantity of goodsand servicesdemanded at a
given price level.
1. Whenthe RBI
increasesthe moneysupply
MS2
Y1
P
Quantityof Output
0
PriceLevel
Aggregatedemand, AD1
(a) The Money Market
Quantityof Money
0
Moneysupply,MS1
r1
InterestRate
(b) The Aggregate-Demand Curve
r2
2. the equilibrium
interest rate falls
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Fiscal policy refers to the governments
choices regarding the overall level of
government purchases or taxes.
Fiscal policy influences saving, investment,
and growth in the long run.
In the short run, fiscal policy primarily
affects the aggregate demand.
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There are two macroeconomic
effects from the change ingovernment purchases:
The multiplier effect
The crowding-out effect
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Aggregate demand,AD1
Quantityof Output
0
PriceLevel
AD21. An increase in governmentpurchases of $20 billioninitially increases aggregatedemand by $20 billion
$20 billion
AD3
2. but the multiplier effect can amplifythe shift in aggregate demand.
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Fiscal policy may not affect the
economy as strongly as predicted by the
multiplier.
An increase in government purchases
causes the interest rate to rise.
A higher interest rate reduces
investment spending.
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This reduction in demand that results
when a fiscal expansion raises the interest
rate is called the crowding-out effect.
The crowding-out effect tends to dampen
the effects of fiscal policy on aggregate
demand.
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AD3
4. which in turnpartly offsets theinitial increase inaggregatedemand.
Aggregate demand,AD1
(b) The Shift in Aggregate Demand
Quantity of Output0
PriceLevel
(a) The Money Market
Quantityof Money
Quantity fixedby the RBI
0
r1
Money demand, MD1
Moneysupply
InterestRate
1. When an increase in governmentpurchases increases aggregate demand
AD2
$20 billion
3. which increases the equilibriuminterest rate
r2
MD2
2.
the increasein spendingincreases moneydemand
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When the government cuts personal
income taxes, it increases households
take-home pay.Households save some of this additional
income.
Households also spend some of it on
consumer goods.
Increased household spending shifts the
aggregate-demand curve to the right.
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The size of the shift in aggregate demand
resulting from a tax change is affected by
the multiplier and crowding-out effects.
It is also determined by the households
perceptions about the permanency of the
tax change.
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There are two implications:
The government should avoid being the
cause of economic fluctuations.
The government should respond to changes
in the private economy in order to stabilize
aggregate demand.
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Some economists argue that monetary
and fiscal policy destabilizes the
economy.
Monetary and fiscal policy affect the
economy with a substantial lag.
They suggest the economy should be leftto deal with the short-run fluctuations on
its own.
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Automatic stabilizers are changes in fiscal
policy that stimulate aggregate demand
when the economy goes into a recessionwithout policymakers having to take any
deliberate action.
Automatic stabilizers include the taxsystem and some forms of government
spending.
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