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Suppose a wave of negative “animal spirits” overruns the economy, and people become pessimistic about the future. What happens to aggregate demand? If the Fed wants to stabilize aggregate demand, how should it alter the money supply? If it does this, what happens to the interest rate? Why might the Fed choose not to respond in this way?

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Principles of Macroeconomics (Mind...

7th Edition
N. Gregory Mankiw
Publisher: Cengage Learning
ISBN: 9781285165912

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BuyFindarrow_forward

Principles of Macroeconomics (Mind...

7th Edition
N. Gregory Mankiw
Publisher: Cengage Learning
ISBN: 9781285165912
Chapter 21.3, Problem 3QQ
Textbook Problem
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Suppose a wave of negative “animal spirits” overruns the economy, and people become pessimistic about the future. What happens to aggregate demand? If the Fed wants to stabilize aggregate demand, how should it alter the money supply? If it does this, what happens to the interest rate? Why might the Fed choose not to respond in this way?

To determine
Pessimism about the future and aggregate demand.

Explanation of Solution

When a wave of pessimism strikes about the future, it discourages household consumption and business investment. This reduces the aggregate demand and the AD curve shifts to the left. Therefore if the Fed wants to stabilize the aggregate demand, then it should increase the money supply, which lowers the interest rate. Hence, the people will get incentives to spend more and save less...

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