Chapter 34

Q:

1. What is the theory of liquidity preference and how does it help explain the downward slope of the aggregate demand curve?
2. Use the liquidity preference theory to explain how decreases in the money supply affect the AD curve.
3. Give an example of a government policy that acts as an automatic stabilizer. Explain why the policy has this effect.

A:

1. The theory of liquidity preference is a theory that states that interest rate adjusts to bring money supply and demand into balance. What this means is that the supply and demand of money will affect how "easy" (cheap) it is to borrow that money, or money will be available to be borrowed at a lower interest rate. This theory helps to explain the downward slope of the aggregate demand curve, basically, the higher the supply of money, the easier(cheaper) it would be for a borrower to obtain an investment loan. The higher the interest rate, the less demand there is for loans. This inverse relationship produces a negative curve.

2. If the quantity of money supplied by the fed decreases, money will be in higher demand, thus yielding a higher interest rate for those that wish to borrow money. Because of a higher interest rate, the quantity demanded of goods and services will decrease. This inverse relationship between money supply and interest rates produces the downward curve.

3. An example of an automatic stabilizer is the government giving unemployment benefits. During an economic downturn, unemployment benefits could possibly allow families to keep "demanding" products that they would not otherwise be able to continue consuming. This lessens the blow of rapidly decreasing demand on an already weak economy. However, when far more unemployment benefits are given out then revenue received, deficits skyrocket. In the short term, however, these benefits can soften the blow of sudden, decreased employment and decreased demand.