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Macroeconomics 21.docx

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University of Maryland
ECON 201

Macroeconomics Chapter 21  How Monetary Policy Influences Aggregate Demand  The most important reason for downward slopingAD is the interest-rate effect!  Theory of liquidity preference: Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance  Money supply  Fed alters through open-market operations (buying and selling bonds) and changing the discount rate  Fixed money supply  Money demand  Money has highest liquidity because it is our medium of exchange. People hold it because it can be used to buy goods and services.  Increase in the interest rate, raises cost of holding money because you could be making money on it in the bank, so the demand decreases.  Downward Slope ofAD curve  Increase in price level, causes an increase in money demand (need more money to pay for more expensive things)  This causes an increase in the interest rates because supply is fixed and demand curve shifts right. (money market graph) • Also quantity of goods demanded decreases (AD curve)  Changes in Money Supply  Whenever the quantity of goods and services demanded changes for any given price level, theAD curve shifts.  When the fed increases money supply, it lowers the interest rate and increases the quantity of goods and services demanded (lower cost t borrowing), shiftingAD curve to the right.  Role of Interest-rate Targets in Fed Policy  Set target for federal funds rate (interest rate banks charge other banks) instead of money supply because it’s
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