Solow model simply took this rate as exogenous. In the Solow model, the saving rate affects growth temporarily, but diminishing returns to capital eventually force the economy to approach a steady state in which growth depends only on exogenous technological progress. By contrast, many endogenous growth models in essence assume that there are constant (rather than diminishing) returns to capital, interpreted to include knowledge. Hence, changes in the saving rate can lead to persistent growth.
Chapter 9
QUESTIONS FOR REVIEW:3,4
3.Why does the aggregate demand curve slope downward?
Aggregate demand is the relation between the quantity of output demanded and the aggregate price level. To understand why the aggregate demand curve slopes downward, we need to develop a theory of aggregate demand. One simple theory of aggregate demand is based on the quantity theory of money. Write the quantity equation in terms of the supply and demand for real money balances as
M/P = (M/P)d = kY,
where k = 1/V. This equation tells us that for any fixed money supply M, a negative relationship exists between the price level P and output Y, assuming that velocity V is fixed: the higher the price level, the
lower the level of real balances and, therefore, the lower the quantity of goods and services demanded
Y. In other words, the aggregate demand curve slopes downward, as in Figure 9–1.
One way to understand this negative relationship between the price level and output is to note the link between money and transactions. If we assume that V is constant, then the money supply determines the dollar value of all transactions:
MV = PY.
An increase in the price level implies that each transaction requires more dollars. For the above identity to hold with constant velocity, the quantity of transactions and thus the quantity of goods and services purchased Y must fall.
4.Explain the impact of an increase in the money supply in the short run and in the long run.
If the Fed increases the money supply, then the aggregate demand curve shifts outward, as in Figure 9–2. In the short run, prices are sticky, so the economy moves along the short-run aggregate supply curve from point A to point B. Output rises above its natural rate level Y: the economy is in a boom.
The high demand, however, eventually causes wages and prices to increase. This gradual increase in prices moves the economy along the new aggregate demand curve AD2 to point C. At the new long-run equilibrium, output is at its natural-rate level, but prices are higher than they were in the initial equilibrium at point A.
Chapter 10
QUESTIONS FOR REVIEW:2, 3,4
2.Use the theory of liquidity preference to explain why an increase in the money supply lowers the interest rate. What does this explanation assume about the price level?
The theory of liquidity preference explains how the supply and demand for real money balances
determine the interest rate. A simple version of this theory assumes that there is a fixed supply of money, which the Fed chooses. The price level P is also fixed in this model, so that the supply of real balances is fixed. The demand for real money balances depends on the interest rate, which is the opportunity cost of holding money. At a high interest rate, people hold less money because the opportunity cost is high. By holding money, they forgo the interest on interest-bearing deposits. In contrast, at a low interest rate, people hold more money because the opportunity cost is low. Figure 10–1 graphs the supply and demand for real money balances. Based on this theory of liquid ity preference, the interest rate adjusts to equilibrate the supply and demand for real money balances.
Why does an increase in the money supply lower the interest rate? Consider what happens when the Fed increases the money supply from M1 to M2. Because the price level P is fixed, this increase in the money supply shifts the supply of real money balances M/P to the right, as in Figure 10–2.
The interest rate must adjust to equilibrate supply and demand. At the old interest rate r1, supply exceeds demand. People holding the excess supply of money try to convert some of it into
interest-bearing bank deposits or bonds. Banks and bond issuers, who prefer to pay lower interest rates, respond to this excess supply of money by lowering the interest rate. The interest rate falls until a new
equilibrium is reached at r2.
3.Why does the IS curve slope downward?
The IS curve summarizes the relationship between the interest rate and the level of income that arises
from equilibrium in the market for goods and services. Investment is negatively related to the interest rate. As illustrated in Figure 10–3, if the interest rate rises from r1 to r2, the level of planned investment falls from I1 to I2.
The Keynesian cross tells us that a reduction in planned investment shifts the expenditure function downward and reduces national income, as in Figure 10–4(A).
Thus, as shown in Figure 10–4(B), a higher interest rate results in a lower level of national income: the
IS curve slopes downward.
4.Why does the LM curve slope upward?
The LM curve summarizes the relationship between the level of income and the interest rate that arises
from equilibrium in the market for real money balances. It tells us the interest rate that equilibrates the money market for any given level of income. The theory of liquidity preference explains why the LM curve slopes upward. This theory assumes that the demand for real money balances L(r, Y) depends negatively on the interest rate (because the interest rate is the opportunity cost of holding money) and positively on the level of income. The price level is fixed in the short run, so the Fed determines the fixed supply of real money balances M/P. As illustrated in Figure 10–5(A), the interest rate equilibrates the supply and demand for real money balances for a given level of income.