economics for managers gtu mba sem 1 chapter 32

7/31/2019 Economics For Managers GTU MBA Sem 1 Chapter 32

1/18

By:

Prof. Sharif Memon


2/18

The aggregate demand curve

slopes downward for threereasons:

The wealth effect

The interest-rate effect

The exchange-rate effect


3/18

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.


4/18

Money demand is determined by several

factors.

According to the theory of liquidity

preference, one of the most important

factors is the interest rate.


5/18

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.


6/18

Quantity ofMoney

InterestRate

0

Moneydemand

Quantity fixedby the RBI

Moneysupply

r2

Md

2

r1

M

d

1

Equilibrium

interest rate


7/18

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


8/18

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.


9/18

There are two macroeconomic

effects from the change ingovernment purchases:

The multiplier effect

The crowding-out effect


10/18

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.


11/18

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.


12/18

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.


13/18

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


14/18

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.


15/18

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.


16/18

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.


17/18

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.


18/18

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.

economics for managers gtu mba sem 1 chapter 32

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