Chapter34/TheInfluenceofMonetaryandFiscalPolicyonAggregateDemandv6291.Definitionofautomaticstabilizers:changesinfiscalpolicythatstimulateaggregatedemandwhentheeconomygoesintoarecessionwithoutpolicymakershavingtotakeanydeliberateaction.2.Themostimportantautomaticstabilizeristhetaxsystem.a.Whentheeconomyfallsintoarecession,incomesandprofitsfall.b.Thepersonalincometaxdependsonthelevelofhouseholds’incomesandthecorporateincometaxdependsontheleveloffirmprofits.c.Thisimpliesthatthegovernment’staxrevenuefallsduringarecession.Thistaxcutstimulatesaggregatedemandandreducesthemagnitudeofthiseconomicdownturn.3.Governmentspendingisalsoanautomaticstabilizer.a.Moreindividualsbecomeeligiblefortransferpaymentsduringarecession.b.Thesetransferpaymentsprovideadditionalincometorecipients,stimulatingspending.c.Thus,justlikethetaxsystem,oursystemoftransferpaymentshelpstoreducethesizeofshort-runeconomicfluctuations.SOLUTIONSTOTEXTPROBLEMS:QuickQuizzes1.Accordingtothetheoryofliquiditypreference,theinterestrateadjuststobalancethesupplyanddemandformoney.Therefore,adecreaseinthemoneysupplywillincreasetheequilibriuminterestrate.Thisdecreaseinthemoneysupplyreducesaggregatedemandbecausethehigherinterestratecauseshouseholdstobuyfewerhouses,reducingthedemandforresidentialinvestment,andcausesfirmstospendlessonnewfactoriesandnewequipment,reducingbusinessinvestment.2.Ifthegovernmentreducesspendingonhighwayconstructionby$10billion,theaggregate-demandcurveshiftstotheleftbecausegovernmentpurchasesarelower.Theshifttotheleftoftheaggregate-demandcurvecouldbemorethan$10billionifthemultipliereffectoutweighsthecrowding-outeffect,oritcouldbelessthan$10billionifthecrowding-outeffectoutweighsthemultipliereffect.3.Ifpeoplebecomepessimisticaboutthefuture,theywillspendless,causingtheaggregate-demandcurvetoshifttotheleft.IftheFedwantstostabilizeaggregatedemand,itshouldincreasethemoneysupply.Theincreaseinthemoneysupplywillcausetheinterestratetodecline,thusstimulatingresid