1. Give an example of a government policy that acts as an automatic stabilizer. Explain why this policy has this effect.
According to our text, automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into recession without policymakers having to take any deliberate action. Automatic stabilizers come in the form of our tax system and government spending. As an individual’s income increases, they get put in a higher tax bracket. When the economy goes into a recession, the amount of taxes the government receives falls. The amount of taxes that the government receives is tied into economic activity so as earnings and incomes fall in a recession, the government’s revenue falls as well. In a recession, more and more people become eligible for benefits such as unemployment benefits, welfare benefits, and other forms of income supplements for the poor.
The increase in government spending stimulates the aggregate demand at the same time that the aggregate demand is insufficient causing the economy to be more stable. Automatic stabilizers act in a quicker fashion than if the government were to create laws in order to stabilize the economy. This would mean that they would have to recognize when a recession is occurring, create, and then enact the law to stabilize the economy. But by the time the effects of the law can be recognized, the recession could have been gone and over with.
2. How would a downward change in the money supply affect you personally? How would it affect your career? What impact would rational expectations have on your decisions in this situation?
3. What is the theory of liquidity preference? How does it help explain the downward slope of the aggregate-demand curve?
The theory of liquidity preference states that the economy’s interest rate adjusts to balance supply and demand. The first piece of the theory of liquidity preference is the supply of money. The Federal Reserve is who controls the money supply. They buy government bonds which are deposited into banks turning the money into funds for the bank reserves. They sell government bonds which make the bank reserves fall. These changes lead to changes in the banks’ ability to make loans and create money. The Federal Reserve can also alter the money supply by changing the amount of reserve
required for each bank to hold or the interest rate at which banks can borrow from the Fed. The second piece of the theory of liquidity preference is money demand.