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Transcript of goods market The market in which goods and services are exchanged and in which the equilibrium level...
AGGREGATE DEMAND IN THE GOODS AND MONEY MARKETS
Chapter outline:Planned Investment and the Interest Rate Other Determinants of Planned
Investment Planned Aggregate Expenditure and
the Interest Rate
Equilibrium in Both the Goods and Money Markets: The IS-LM Model
Policy Effects in the Goods and Money Markets Expansionary Policy Effects Contractionary Policy Effects The Macroeconomic Policy Mix
The Aggregate Demand (AD) Curve The Aggregate Demand Curve: A
Warning Other Reasons for a Downward-Sloping
Aggregate Demand Curve Shifts of the Aggregate Demand Curve
from Policy Variables
27
goods market
The market in which goods
and services are exchanged
and in which the equilibrium
level of aggregate output
is determined.
money market
The market in which financial instruments are exchanged and in which the equilibrium level of the interest rate is determined.
The links between goods and money markets:
The money market determines the interest rate. The demand for money in the money market is affected by income (which is determined in the goods market).
The goods market determines income, which depends on planned investment. Planned investment in turn depends on the interest rate (which is determined in the money market).
The key link between the two markets is the interest rate…
Planned Investment and the Interest Rate
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.
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, its
expectation of future sales.
The optimism or pessimism of entrepreneurs about the future course of the economy can have an
important effect on current planned investment.
Keynes used the phrase animal spirits to describe the feelings of entrepreneurs, and he argued that these
feelings affect investment decisions.
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 planned aggregate expenditure is the sum of consumption, planned investment,
and government purchases.
That is,
AE ≡ C + I + G
Planned Aggregate Expenditure and the
Interest Rate
An increase in the interest rate from 3
% to 6 % lowers
planned aggregate
expenditure and thus reduces
equilibrium income from
Y0 to Y1
Planned Aggregate Expenditure and the
Interest Rate
The effects of a change in the interest rate 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 (income) (Y) by a multiple of the initial decrease in planned investment.
r I AE Y
r I AE Y
Equilibrium in Both the Goods and Money Markets: The IS-LM Model
rMY
rMYd
d
An increase in the interest rate (r) decreases output (Y) in the goods market because an increase in
interest rate lowers planned investment.
When income (Y) increases, this shifts the money demand curve to the right, which increases the
interest rate (r) with a fixed money supply.
Equilibrium in Both the Goods and Money Markets:
The IS-LM Model
Planned investment depends on the interest rate, and money demand depends on
aggregate output.
The IS Curve
Each point on the IS curve
corresponds to the equilibrium
point in the goods market for
the given interest rate.
When government spending (G)
increases, the IS curve shifts to the right, from
IS0 to IS1.
IS curve A curve illustrating the negative relationship between the equilibrium value of aggregate output (income)
(Y) and the interest rate in the goods market.
The LM Curve
Each point on the LM curve
corresponds to the equilibrium point in the money market for the given value of aggregate output
(income).
Money supply (Ms) increases shift the
LM curve to the right, from LM0 to
LM1.
LM curve A curve illustrating the positive relationship between the equilibrium value of the interest rate and aggregate output (income) (Y) in the money market.
The IS-LM Model
The IS-LM Diagram
Equilibrium in the goods market (IS). Equilibrium in financial markets (LM).
When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.
The IS-LM Model
The IS-LM diagram is a useful way of seeing the effects of changes in monetary and fiscal policies on equilibrium aggregate output (income) and the
interest rate through shifts in the two curves.
Always keep in mind the economic theory that lies behind the two curves.
Do not memorize what curve shifts when; be able to understand and explain why the curves shift.
This means going back to the behavior of households and firms in the goods and money
markets.
An Increase in Government Purchases (G)
When G increases, the IS curve shifts to the right. This increases the equilibrium value of both Y and r.
An Increase in the Money Supply (Ms)
When Ms increases, the LM curve shifts to the right. This increases the equilibrium value of Y and decreases the
equilibrium value of r.
Policy Effects in the Goods and Money MarketsExpansionary Policy Effects:
expansionary fiscal policy - An increase in government spending or a reduction in net taxes aimed at increasing aggregate output (income) (Y).
expansionary monetary policy - An increase in the
money supply aimed at increasing aggregate output (income) (Y).
Contractionary Policy Effects: contractionary fiscal policy - A decrease in
government spending or an increase in net taxes aimed at decreasing aggregate output (income) (Y).
contractionary monetary policy - A decrease in the money supply aimed at decreasing aggregate output (income) (Y).
Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a
Decrease in Net Taxes (T)
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.
crowding-out effect The tendency for increases in government spending to cause reductions in
private investment spending.
Effects of an expansionary fiscal policy:
increase not did if than less increases rY
IrMYG d
Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a
Decrease in Net Taxes (T)
Expansionary Monetary Policy: An Increase in the Money Supply
Effects of an expansionary monetary policy:
increase not did if than less decreases d
Mr
ds MYIrM
Contractionary PolicyContractionary Fiscal Policy:
A Decrease in Government Spending (G) or an Increase in Net Taxes (T)
Contractionary Monetary Policy: A Decrease in the Money Supply
Effects of a contractionary fiscal policy:
decrease not did if than less decreases
or
rY
IrMYTG d
Effects of a contractionary monetary policy:
decrease not did if than less increases d
Mr
ds MYIrM
The Macroeconomic Policy Mix
policy mix The combination of monetary and fiscal policies in
use at a given time.
The Impact of an Increase in the Price Level on the Economy —Assuming No Changes in G, T, and Ms
The Aggregate Demand (AD) Curve
The Aggregate Demand (AD) Curve
aggregate demand (AD) curve A curve that shows the negative relationship between aggregate output (income) and the price level. Each point on the AD curve is a
point at which both the goods market and the money market are in equilibrium.
At all points along the AD curve, both the
goods market and the money market are in
equilibrium.The policy variables G,
T, and Ms are fixed.
The Aggregate Demand Curve
The Aggregate Demand Curve: A WarningIt is important that you realize what the aggregate demand
curve represents.
The aggregate demand curve is more complex than a simple individual or market demand curve.
The AD curve is not a market demand curve, and it is not
the sum of all market demand curves in the economy.
To understand what the aggregate demand curve represents,
you must understand the interaction betweenthe goods market and the money markets.
Other Reasons for a Downward-Sloping Aggregate Demand
CurveThe Consumption Link
The consumption link provides another reason for the AD curve’s downward slope.
An increase in the price level increases the demand for money, which leads to an increase in
the interest rate, which leads to a decrease in consumption (as well as planned investment), which leads to a decrease in aggregate output
(income).
The initial decrease in consumption (brought about by the increase in the interest rate)
contributes to the overall decrease in output.
The Real Wealth Effect
real wealth, or real balance, effect The change in consumption brought about by a change in real wealth that results from a change
in the price level.
Other Reasons for a Downward-Sloping Aggregate Demand
Curve
An increase in the money supply (Ms)
causes the aggregate demand curve to shift to the right, from AD0
to AD1. This shift occurs
because the increase in Ms lowers the
interest rate, which increases planned
investment (and thus planned aggregate
expenditure). The final result is an increase in output at each possible price
level.
Shifts of the Aggregate Demand Curve from Policy Variables
An increase in government purchases (G) or a decrease in net taxes (T) causes the
aggregate demand curve to shift to the right, from AD0
to AD1. The increase in G increases
planned aggregate expenditure, which leads to
an increase in output at each possible price level.A decrease in T causes consumption to rise.
The higher consumption then increases planned aggregate expenditure,
which leads to an increase in output at each possible
price level.
Shifts of the Aggregate Demand Curve from Policy
VariablesThe Effect of an Increase in Government Purchases or a Decrease in Net Taxes on the AD Curve
Shifts of the Aggregate Demand Curve from Policy Variables
Factors That Shift the Aggregate Demand Curve: