© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case,...

© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster

12PART III THE CORE OF MACROECONOMIC THEORY

Aggregate Demand

in the Goods andMoney Markets

Fernando & Yvonn Quijano

Adapted from:

CHAPTER OUTLINE

Planned Investment and the Interest Rate

Equilibrium in Both the Goods and MoneyMarkets

Policy Effects in the Goods and MoneyMarkets

The Aggregate Demand (AD) Curve

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 2 of 31

In Chapters 8 & 9, we focused on the goods market, exploring how the equilibrium level of aggregate output (Y) is determined.

Y = C + I + G

In Chapters 10 & 11, we looked at the money market, examining how the equilibrium level of interest rate (r) is determined.

Md = Ms

However, the goods and money markets do not operate independently. Events in one market have effects on the other.

In this chapter, we will bring the two markets together, in so doing explaining the links between Y and r. We also derive the aggregate demand (AD) curve, which explores the relation between Y and the price level (P).

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12.1 Planned Investment and the Interest Rate

In Chapters 8 & 9, we assumed for simplicity, that planned investment is fixed.

In practice, planned investment spending is a negative function of the interest rate.

An increase in the interest rate from 3 percent to 6 percent reduces planned investment from I0 to I1.

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Other Determinants of Planned Investment

The assumption that planned investment depends only on the interest rate is obviously a simplification, just as is the assumption that consumption depends only on income.

In practice, the decision of a firm on how much to invest depends on, among other things:

• expectation of future sales

• capital utilization rates

• relative capital and labor costs

• productive technology

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Planned Aggregate Expenditure and the Interest Rate

We can use the fact that planned investment depends on the interest rate to consider how planned aggregate expenditure (AE) depends on the interest rate.

Recall that: AE ≡ C + I + G

r I AE Y

r I AE Y

A negative relationship exists between r and Y in the goods market.

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Planned Aggregate Expenditure and the Interest Rate

An increase in the interest rate from 3 percent to 6 percent lowers planned aggregate expenditure and thus reduces equilibrium income from Y0 to Y1.

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The effects of an increase in interest rate from 3% to 6% include:

A high interest rate (r) discourages planned investment (I).

Planned investment is a part of planned aggregate expenditure (AE).

Thus, when the interest rate rises, planned aggregate expenditure (AE) at every level of income falls.

Finally, a decrease in planned aggregate expenditure lowers equilibrium output Y by a multiple of the initial decrease in planned investment (investment multiplier).

To recall, any changes to Md or Ms in the money market will change the equilibrium interest rate r. However, the effect is not confined to the money market, but will spillover to the goods market via planned investment (I). Eventually, equilibrium output Y will be affected.

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12.2 Equilibrium in Both the Goods and Money Markets

However, when income (Y) increases, it affects the equilibrium in the money market. That is, the money demand curve shifts to the right, which increases the interest rate (r) with a fixed money supply. We can thus write:

rMY

rMYd

d

A positive relationship exists between r and Y in the money market.

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In the goods market, for a given value of r, we can determine the equilibrium value of Y (because I depends on r).

In the money market, for a given value of Y, we can determine the equilibrium value of r (because money demand depends on Y).

How do we find the one pair of Y and r that achieves overall equilibrium in both the goods and money markets? (We will use the IS-LM curves)

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In the goods market:

When r , Y When r , Y

Each point on the IS curve represents the equilibrium point in the goods market for a given r.

The IS Curve

There exists a negative relationship between the equilibrium value of Y and r (IS curve)

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The LM Curve

In the money market:

When Y , r When Y , r

There exists a positive relationship between the equilibrium value of r and Y (LM curve)

Each point on the LM curve represents the equilibrium point in the money market for a given Y.

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The point at which the IS and LM curves intersect corresponds to the point at which both the goods market and the money market are in equilibrium.

The IS-LM Diagram

The equilibrium values of aggregate output and the interest rate are Y0 and r0.

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12.3 Expansionary Policy Effects in the Goods and Money Markets

expansionary fiscal policy An increase in government spending or a reduction in net taxes aimed at increasing aggregate output (Y).

expansionary monetary policy An increase in the money supply aimed at increasing aggregate output (Y).

)Y toY (from )G toG (from 1010 YAEG

(1) Expansionary Fiscal Policy: An Increase in G or a Decrease in T

Goods Market

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rMY d

Money Market

Goods Market

)Y toY (from effect)out -(crowding *1 YAEIr

An expansionary fiscal policy tends to lead to a crowding-out effect. In this case, the reductions in private investment spending (I).

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An increase in government spending G from G0 to G1 shifts the planned aggregate expenditure schedule from 1 to 2.

The crowding-out effect of the decrease in planned investment (brought about by the increased interest rate) then shifts the planned aggregate expenditure schedule from 2 to 3.

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The size of the crowding-out effect depends on:

1)The action of the central bank in the money market. If the central bank increases money supply simultaneously such that r remains unchanged, then there would be no crowding out effect.

2)The sensitivity of planned investment to changes in the interest rate. If the slope of the investment curve is very steep, then there is little change in I as a result of changes in r.

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In the goods market, an increase in G will raise the equilibrium value of Y at the same level of r.

This implies that the IS curve will shift to the right from IS0 to IS1.

Graphical Depiction via IS-LM Diagram

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So, when the government pursues an expansionary fiscal policy, the IS curve shifts to the right from IS0 to IS1.

At the new equilibrium point, both the Y and r have increased.

As noted earlier, if r did not increase, there will be no crowding-out effect, and Y will increase even more.

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(2) Expansionary Monetary Policy: An Increase in Ms

Effects of an expansionary monetary policy:

increase not did if than less decreases d

Mr

ds MYIrM

In the money market, an increase in Ms will decrease the equilibrium value of r at the same level of Y.

This implies that the LM curve will shift to the right from LM0 to LM1.

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So, when the government pursues an expansionary monetary policy, the LM curve shifts to the right from LM0 to LM1.

At the new equilibrium point, Y increases but r falls.

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Effects of a contractionary fiscal policy:

decrease not did if than less decreases

or

rY

IrMYTG d

12.4 Contractionary Policy Effects in the Goods and Money Markets

(1) Contractionary Fiscal Policy: A Decrease in G or an Increase in T

contractionary policies aimed at decreasing aggregate output (Y), often used to fight inflation.

It will be clearer to use the IS-LM Diagram, where the IS curve shifts to the left. At the new equilibrium point, both Y and r decrease.

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Effects of a contractionary monetary policy:

decrease not did if than less increases d

Mr

ds MYIrM

(2) Contractionary Monetary Policy: A Decrease in Ms

It will be clearer to use the IS-LM Diagram, where the LM curve shifts to the left. At the new equilibrium point, Y decreases but r increases.

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policy mix The combination of monetary and fiscal policies in use at a given time.

TABLE 12.1 The Effects of the Macroeconomic Policy Mix

Fiscal Policy

MonetaryPolicy

)or (

ryExpansiona

TG )or (

naryContractio

TG

)(

ryExpansionasM

)(

naryContractiosM

CIrY ?,?,, ?,,?, CIrY

?,,?, CIrY CIrY ?,?,,

12.5 Macroeconomic Policy Mix Effects in the Goods and Money Markets

It will be clearer to use the IS-LM Diagram

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12.6 The Aggregate Demand (AD) Curve

The AD curve shows the equilibrium levels of Y associated with different price levels (P) in the economy, taking into account the behavior of firms and households in both the goods and money markets at the same time.

The AD curve is derived by assuming the government does not take any action (G, T or Ms) to affect the economy in response to changes in P.

The AD curve shows the relation between the aggregate quantity of goods demanded (C + I + G) and the price level P.

To derive the AD curve, we examine what happens to Y when P changes.

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FIGURE 12.5 The Impact of an Increase in the Price Level on the Economy—Assuming No Changes in G, T, and Ms

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Each point on the AD curve is a point at which both the goods market and the money market are in equilibrium.

From the slide, it is clear that:

When P , Y When P , Y

A negative relationship exists between P and Y.

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Alternative: Deriving the AD curve using IS-LM framework

For a given price level (P) the aggregate quantity of output demanded is determined where the IS and LM curves intersect.

For instance, at P0, the equilibrium point is at E, with the corresponding output at Y0.

When P to P1, the LM curve shifts to the left due to a reduction in real money supply. At the new equilibrium point of F, the aggregate quantity of output demanded falls from Y0 to Y1.

IS

LM0 (P = P0)

E

LM1 (P = P1)

F

Y0Y1Y0

Y

r

Y

P

Y1

P0

AD

E

F

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The Aggregate Demand (AD) Curve: A Warning

The AD curve is more complex than a simple individual or market demand (DD) curve. The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy.

Even though both the AD and DD curves are download-sloping, the reasons behind are different.

Why DD curve is downward-sloping?Substitution effect Income effect

Why AD curve is downward-sloping?Interest rate link. An increase in the price level reduces the real money supply, and shifts the LM curve to the left. At the new equilibrium point, interest rate increases, which reduces the demand for goods by households and firms.

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Other Reasons for a Downward-Sloping AD Curve

(1) The Consumption Link

Even though we have assumed that consumption (C) depends only on income (Y), in practice, interest rates also affect the level of C.

i.e. when r , I and C at the same time

So, when P , Md (shifts to the right), r , C (and I ), AE , Y

The consumption link thus explains the negative relationship between P and Y.

(2) The Real Wealth (or Real Balance) Effect

When P , your real wealth (erosion in purchasing power), C , AE , Y

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At a fixed level of P, if Ms , r , I and C , AE , Y .

Thus, the AD curve will shift to the right, from AD0 to AD1.

The AD curve will shift if any of the policy variables (Ms, G, T) change.

12.7 The Shifts in Aggregate Demand (AD) Curve

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As for a decrease in T, C , AE , Y (again, there will be crowding-out effect from the interaction with money market).

The AD curve will also shift to the right, from AD0 to AD1.

At a fixed level of P, if G , AE , Y (though some of the increases will be crowded out due to a fall in interest rate in the money market).

Thus, the AD curve will shift to the right, from AD0 to AD1.

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Summary: Factors That Shift the AD Curve

The aggregate demand is determined by the intersection of the IS and LM curves. Hence, holding the price level constant, any factor that causes the equilibrium point to shift will also move the AD curve in a similar direction.

Please take note that the choice of IS-LM and AD-AS depends on the issue addressed.

The IS-LM framework relates the interest rate to output; whereas the AD-AS relates the price level to output.

© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case,...

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