Chp. 34

Chapter 34 covers how a government's monetary (supply of money set by the central bank) and fiscal (the levels of governments spending and taxation set by the president and Congress) policies affect aggregate demand. The aggregate demand curve shows the total quantity of goods and services demanded in the economy for any price level. For the U.S economy the most important reason for the downward slope of the aggregate demand curve is the interest rate effect. The theory of liquidity preference is Keyne's theory that the interest rate adjusts to bring money supply and money demand into balance.    The nominal interest rate is the interest rate usually reported, and the real interest rate is the interest rate corrected for the effects of inflation. The first piece of the theory of liquidity preference is the supply of money, which is controlled by the federal reserve. The fed can alter the money supply through open-market operations, changing reserve requirements (amount of reserves banks must hold against deposits) or the discount rate (interest rate at which banks can borrow reserves from the fed). In this chapter the money supply will be fixed, therefore a vertical curve. The second piece of the theory of liquidity preference is the demand for money. The liquidity of money explains the demand for it: people choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services. If the interest rate is above the equilibrium level the quantity of money people want to hold is less than the quantity the fed has created.