Chapter 32 The Influence of Monetary  and Fiscal Policy on Aggregate Demand
 
ch24-25 we saw how fiscal policy affects saving, investment and long-run economic growth.
ch27-28 we saw how the Fed controls the money supply and how the money supply affects the price level in the long run.

32.1 How Monetary Policy  Influences Aggregate Demand
ADC down-ward sloping:
***Pigou's wealth effect;(lease important)
***Keynes's interest-rate effect;(most important)
***Mundell-Fleming's exchange-rate effect.(important for small country)
These three effects should not be viewed as alternative. They occur simultaneously to increase the quantity of goods and services demanded when the price level falls.

32.1.1Theory of Liquidity Preference
Theory of Liquidity Preference: Keynes's theory that the interest rate adjusts to bring money supply and money demand into balance.

Money Supply is controled by the Fed(three control variables). We assume the money supply is fixed and it does not depend on the interest rate. Vertical money supply curve.

Money Demand: money is medium of exchange. People choose to hold money instead of other assets that offer higher rates of return because moeny can be used to buy goods and services.
The most important thing is interest rate, since it  is the opportunity cost of holding money. An increase in the interest rate raises the cost of holding money and , as a result reduces the quantity of money demanded.(down-ward sloping demand curve)

The Keynes's interest-rate effect can be summarized in three steps:
1. A higher price level raises money demand.
2. Higher money demand leads to a higher interest rate.
3. A  higher interest rate reduces the quantity of goods and services demanded.

Changes in the Money supply
if the Fed increases the money supply, interest rate falls. Monetary injection shifts the aggregate demand curve to the right.

Interest-rate targets and Fed Policy
The Fed treat interest rate as the Fed's policy instrument.
the federal funds rate: the interest rate that banks charge one another for short-term loans.

Monetary policy can be decribed either in terms of the money supply or in terms of the interest rate.
A change in monetary policy that aims to expand aggregate demand can be described either as increasing the money supply or lowering the interest rate. A change in monetary policy that aims to contract aggregate demand can be described either as decreasing the money supply or raising the interest rate.

32.2  How  Fiscal Policy  Influences Aggregate Demand
Fiscal Policy refers to the government's choices regarding the overall level of government purchases or taxes.

We have learned how fiscal policy influences saving, investment and growth in the long run. In the short run, the primary effect of fiscal policy is on the aggregate demand for goods and services.

32.2.1 Changes  in government purchases
***the multiplier effect: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.
(marginal propensity to consume--MPC)  Please read page 718 FYI box.

***the crowding out effect: the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending.

an increase in govn't purchasing stimulates the demand for goods a nd services, it also causes the interest rate to rise, and a higher interest rate tends to choke off the demand for goods and services. this reduction in demand that results when a fiscal expansion raises interest rate is called crowding out effect.

When the gov't increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding out effect is larger.

32.2.2 Changes in Taxes
The other important instrument of fiscal policy is the level of taxation.
Cut tax will shift AD to the right, it depends on whether the multiplier effect or crowding out effect is larger.
another important determinant of the size of the shift in AD :perceptions about whether the tax change is permanent or temporary.
if household expect the tax cut to be permanent, increase spending by a large amount, thus tax cut will have a large impact on AD.
if household expect the tax cut to be temporary, they don't increase spending, tax cut only have a small impact on AD.

32.3 Using Policy to Stabilize The Economy
Should policymakers use these instruments in order to control AD and stabilize the economy?
***The case for active stabilization policy
the government can adjust its monetary and fiscal policy in response to these waves of opeimism and pessimism and thereby, stabilize AD.

***The case against active stabilization policy
these policies(monetary and fiscal policy)
affect the economy with a substantial lag.

32.3.1 automatic stabilizers: changes in fiscal policy that stimulate aggregate demand when the economy goes into  a recession without policymakers having to take any deliberate action.

The most important automatic stabilizer is the tax system.
When the economy goes into a recession, the amount of taxes collected by the gov't falls automatically b/c almost all taxes are closely tied to economic activity. the automatic tax cut stimulates AD and, thereby, reduces the magnitude of economic fluctuations.

In recession, taxes fall, govn't spending rises(welfare benefits, unemployment insurance benefits), and the gon't budget moves toward deficit. If the gov't faced a strict balanced-budget rule, it would be forced to look for ways to raise taxes or cut spending in a recession. In other words, a strict balanced-budget rule would eliminate the automatic stabilizers inherent in our currenty system of taxes and government spending.

32.4 The economy in the long run and the short run
three macroeconomic variables are of central important: output, the interest rate, and the price level.

(In the long run)According to the classical macroeconomic theory we learned in chapters 24, 25 and 28, these variables are determined as follows:

1. output is determined by the supplies of capital and labor and the availabel production technology for turning capital a nd labor into output.
2. For any given level of output, the interest rate adjusts to balance the supply and demand for loanable funds.
3. The price level adjusts to balance the supply and demand for money. Changes int he supply of money lead to proportionate changes in the price level.