Chapter 34 Group C Homework

Homework for Group C
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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.

1. Liquidity preference indicates that in the short run, interest rate adjusts to bring money supply and demand into balance. When the overall price level rises, in any given interest rate, people need more money to buy the same goods & services. If money supply stays the same, the interest rate must rise to offset the additional money demand. And the rise of interest rate increase the cost of investment & loan, therefore shift the aggregate demand curve to the left.

2.  If the Fed decreases the money supply, it will drive up the interest rate, and a higher interest rate makes investment more costly. Therefore, this would reduce the aggregate demand (shift to the left).

3. An example of a government policy that acts as an automatic stabilizer is the unemployment insurance. This is because the decrease of aggregate demand must rise unemployment rate. This policy will provide those who lost their job some extra money so that they could keep their spending.